GREENSPAN’S PEAK WAS NASDAQ’S - PART 1
By James Grant
Sen. Phil Gramm (R., Texas): “If this is the bust, the boom was sure as hell worth it. You agree with that, right?”
Alan Greenspan: “Certainly.”
The Wall Street Journal, which last week reported this committee-room exchange, omitted an important detail. The Federal Reserve chairman is no impartial observer of the boom he was asked to appraise. He seeded it, accommodated it, celebrated it and defended it from those who believed they saw it turn into a bubble. He was as uncritically and besottedly bullish as the luckless brokerage-house analysts who have fallen under the gaze of the Washington inquisitor, Rep. Richard H. Baker (R., La.). Not long ago, Greenspan even believed the analysts.
The chairman’s analytical record, hazy in most memories (though not in that of the vigilant Bill Fleckenstein, author of the daily Market Rap on www.grantsinvestor.com), constitutes an important piece of the U.S. interest-rate equation. The structure of forward rates is set by the market in partnership with the Second Most Powerful Man in the World. Insofar as Greenspan leads the market, it is a case of a one-eyed man leading people with two. Perhaps, after they refresh themselves on the chairman’s errant judgment - especially off the beam on the eve of the 2000 stock-market peak - the sighted will have more confidence in their own judgment.
As it is, they seem to yield to the chairman. The money-market interest rate and domestic equity markets are priced for a prompt recovery from a downturn neither unusually severe nor protracted. By the shape of the forward Eurodollar curve and the bull-market P/E affixed to the S&P 500 (33 times trailing net income), Mr. Market has thrown in his lot with Greenspan and Gramm. A few quarters of weak GDP growth? A collapse in capital spending offset, in part, by the indomitable leveraged consumer? Is that all there is?
No, it seems to us. In support of this contention, we offer two preliminary propositions. No. 1: Booms not only precede busts, they also cause them. No. 2: Busts are indispensable. At least - behold Japan - no proper boom can be built on the uncleared debris of a preceding boom.
What is this debris? Business and financial error as reflected in misbegotten investment projects, bad debts, impaired balance sheets, wild expectations. The job of the bust is to redress these mistakes - in effect, to mark them to market. Americans, quick to acknowledge their own error and quick to forgive it in others (after the resolution of pending litigation, of course), disposed of the wreckage of the 1980s in short order. As the bubble of the late 1990s dwarfed that of the late 1980s, the cleanup will take longer than the market currently seems to allow for. Thus, we believe, money-market interest rates will continue to fall, the pattern of business activity will describe no letter “V,” and the long-awaited recovery in corporate earnings will be pushed well into 2002.
With the telecom and Internet bubbles popped, some would say that the adjustment is nearly complete. In the last cycle, the pace of adjustment was checked by the nature of the problems - overvalued buildings and illiquid banks.
Neither was susceptible to an instant cure. In contrast, stock prices, when they get around to falling, fall fast. However, we think, the millennial adjustment is far from over. Telecom and tech were not the whole bubble, only the most visible portion. The bubble was global. It distorted not only the structure of the U.S. economy but also the patterns of world trade. It exaggerated the economic feats of the one and only superpower and enlarged the U.S. current-account deficit. It caused an even greater round trip of dollars - into the hands of overseas creditors and back into U.S. securities markets - than might have otherwise occurred.
It would be just like Gramm and Greenspan to agree that, with respect to these huge foreign inflows, “no harm, no foul.” So concluding, however, they would underestimate the risks of investing in highly valued markets in a highly valued currency. The sheer persistence of overvaluation in the United States has dulled investors’ perceptions of it. News that $10.6 billion had flowed into U.S. equity mutual funds in June did not elicit the logical question: At these valuations, why was there any? Commentators, instead, wondered why there wasn’t more. (“Asset levels for equity mutual funds are much higher now than in 1998 or 1999,” writes a dissenting commentator, James Bianco, proprietor of Bianco Research, Barrington, Ill. “Despite the stock market sell-off, only two months have seen outflows since the market peak in 2000.”)
The fundamental cause of the bubble was the mispricing of capital and credit, therefore of risk. In the hottest, most bubble-like sectors of the economy, investment projects were undertaken purely because money or credit was available to finance them. The viability of these ventures depended on the continued availability of ultra-cheap financing. When capital and credit became less cheap, the boom-time ventures became less viable. The massive write-downs of goodwill by Nortel Networks and JDS Uniphase begin to suggest how far from viability it is possible to wander. In the case of JDS, $44.8 billion of acquisitions made during “The Fabulous Decade” (to borrow the title of a new book on the 1990s by Clinton Fed appointees Alan Blinder and Janet Yellen) turn out to be worthless.
Money was easy late in the decade, and when the capital markets chose to make it tight, as in the wake of the 1998 Long-Term Capital Management affair, the Fed insisted on making it easy again. The Fed raised the funds rate three times in 2000, at last to 61/2% on May 16, two months after the Nasdaq peaked.
Was the Fed therefore leaning against the wind? Not the chairman, who contributed to the pro-cyclical gale in a speech on March 6, 2000, before the Boston College Conference on the New Economy. His subject: “The Revolution in Information Technology.” As he spoke, orders for high-tech durable goods in the second quarter were on their way to registering a year-over-year gain of 25%.
Four quarters later, in April-June 2001, following a sharp rise in the cost of speculative capital, they would register a 31% decline, the steepest on record. John Lonski, Moody’s chief economist, aptly describes the nearby graph (which depicts the surge and plunge) as “the picture of a bubble.”
It was no bubble to the chairman when he rhapsodized on information technology and productivity growth. Thanks to computer technology, Greenspan declared, business managers were increasingly able to formulate decisions using “real-time” information. Not anticipating how rare a commodity “visibility” would shortly become, he said that this knowledge had reduced uncertainty. “When historians look back at the latter half of the 1990s a decade or two hence,” he told his Boston audience, “I suspect they will conclude we are now living through a pivotal period in American economic history. New technologies that evolved from the cumulative innovations of the past half-century have now begun to bring about dramatic changes in the way goods and services are produced and in the way they are distributed to final users. Those innovations, exemplified most recently by the multiplying uses of the Internet, have brought on a flood of start-up firms, many of which claim to offer the chance to revolutionize and dominate large shares of the nation’s production and distribution system. And participants in capital markets, not comfortable in dealing with discontinuous shifts in economic structure, are groping for the appropriate valuations of these companies. The exceptional stock price volatility of these newer firms, and, in the view of some, their outsized valuations, indicate the difficulty of divining the particular technologies and business models that will prevail in the decades ahead.”
Striking the pose of a benevolently optimistic monetary statesman, Greenspan appeared hopeful, yet heedful of the risks. Heedlessness set in a few paragraphs later. “At a fundamental level,” he said, “the essential contribution of information technology is the expansion of knowledge and its obverse, the reduction in uncertainty. Before this quantum jump in information availability, most business decisions were hampered by a fog of uncertainty. Businesses had limited and lagging knowledge of customers’ needs and of the location of inventories and materials flowing through complex production systems. In that environment, doubling up on materials and people was essential as a backup to the inevitable misjudgments of the real-time state of play in a company. Decisions were made from information that was hours, days, or even weeks old.”
Thanks to the clarity afforded by instantaneous communications, Cisco Systems had to write off only $2.25 billion in excess inventories during its third fiscal quarter, in addition to just $1.17 billion in restructuring and other special charges. Using the older technologies -telephone, fax, the mails, citizens’ band radio, etc.- the loss would undoubtedly have been greater.
Throughout Silicon Valley, makers of PCs, chips, servers, printers and other digital products have admitted to monstrous miscalculations of final demand.
Lucent, Corning, Nortel and JDS Uniphase have been devastated by one of the greatest misallocations of investment capital outside the chronicles of the Soviet Gosplan.
Who can conceive of the size of this waste had there been no e-mail?
More tomorrow...
James Grant,
for The Daily Reckonning |
