Excellent article in Barron's this weekend:
interactive.wsj.com
-----------
The Fed Should Act Now
It has let market speculation get out of hand
By David Rocker
The health and vitality of the U.S. economy have become dependent on a
robust stock market. In an important speech at Jackson Hole, Wyoming,
several months ago, Alan Greenspan indicated that the Fed is now sensitive to
the potential for the stock market itself to cause an inflationary overheating of
the economy. Based on the Fed's own model -- even after last week's selloff
-- the market has never been as expensive as it is now. Not in 1929, not in
1987, never.
Much of the market's inexorable rise stems from the democratization of
investing. CNBC, Bloomberg and CNN, among others, pour out a steady
stream of stock-market information to homes, airports, bars and even the
sides of buildings. The American people have gotten the message. Never
before have so many invested so heavily, confident that the market cannot go
down for any sustained period.
Investors have become increasingly
complacent because there have been so
few meaningful declines over the past
two decades and markets have
snapped back quickly from those
setbacks. The assumption that past
trends will persist, the essential
analytical basis for the Dow 36,000
theorists, is a dangerous one. Long-Term Capital Management regularly
earned nearly 40% a year. On that basis, one might have extrapolated a
similar growth rate in 1998 with little volatility. They lost 90% of their capital
in a month.
In the current feverish environment, it may be helpful to reflect on some
traditional verities.
First, price matters in making an investment decision. While the Mercedes is a
good car, it is probably not a sensible purchase at $500,000. While earnings
of U.S. stocks have grown over the past decade, that growth rate has been
unexceptional and P/Es have never been this high, even during periods of
lower inflation and faster earnings growth.
Second, reported earnings are of sufficiently low quality that the Securities
and Exchange Commission has become more vocal on this issue. Chief
financial officers seem to have had at least as much to do with reported profit
gains in recent years as chief operating officers. Corporations have been
telling their shareholders a story far more optimistic than the one they're telling
the tax collector. Federal corporate tax receipts were actually lower in 1999
than in 1998 and the Congressional Budget Office expects another decline
this year. Investors have been piling into technology stocks to the exclusion of
others because of their supposedly brighter earnings prospects, yet Dell, Intel,
IBM, Hewlett-Packard, Lexmark and Xerox, among others, have recently
had disappointing quarters.
Third, interest rates matter and they have been rising significantly around the
world. Stocks have soared even though yields on long U.S. Treasury bonds
have risen nearly 30% over the past year. Internet and other high-P/E stocks,
which logically should have been the most adversely affected by rising rates
because their multiples are high and their payouts more distant, have risen the
fastest in this twilight zone of a stock market.
Fourth, as Long-Term Capital Management showed, leverage increases
volatility. Investors have dramatically increased their leverage to maximize
returns. Margin loans have risen vertically in the past several years to record
levels. While it is not easily measured, it is also clear that large sums have
been borrowed against homes and credit cards for stock purchases. Similarly,
percentage cash reserves at mutual funds have been drawn down almost to
all-time lows. Everyone owns the same small group of large-capitalization
technology stocks. Investors are behaving like sheep on margin. The
American public has committed the greatest percentage of its assets to the
most expensive stock market in history at a time when the Federal Reserve is
overtly tightening, our external deficit is swelling and cash reserves are low.
This insensitivity to risk is dangerous.
The Federal Reserve and other government agencies have been significantly
responsible for this euphoria because of the asymmetry of their policies. The
Fed argues that markets should be free of government intervention, but it
seems that such views are espoused only so long as markets are rising. When
the market crashed in 1987, the Fed intervened. When banks and savings and
loans were bankrolling wildly risky deals, the government looked on and did
nothing. When this recklessness produced vast losses, the government
stepped in to bail out the speculators -- at enormous public expense. When
LTCM overleveraged itself, regulators sat idly by. When its collapse in 1998
led to a market decline, the Fed stepped in again to coordinate the bailout, cut
interest rates and pump in money. Once again, the government stopped
natural corrective forces from punishing speculators, as always cloaking its
actions in the mantle of the national interest. The message to the investing
public has been clear: "The government will protect you from the downside
but will not restrain your upside." Why not speculate?
As the "buy the dip" mentality is now so fully ingrained as to prevent all but a
sudden steep decline, the risk has risen that this market will end violently,
threatening our prosperity. The economy would clearly suffer after a sharp
selloff because so many consumers are now so heavily invested. Real-estate
values would fall. With U.S. equities out of favor, the demand for dollars
would shrink, forcing the U.S. to pay higher interest rates to attract foreign
capital to cover our rising trade deficit. The combination of a weaker
economy and rising interest rates would further depress the stock market. In
essence, the whole positive cycle we have enjoyed in the past decade would
be thrown into reverse. Of course, the Federal Reserve would then be
expected to again intervene.
Fed officials have periodically expressed concern about market valuations and
speculation, but then the governors reverse themselves with "new paradigm"
speeches and commitments not to raise margin requirements. Each reversal
has brought forth a new burst of unbridled investor enthusiasm. The 100
largest Nasdaq stocks rose 102% last year and are selling at over 130 times
earnings. The IPO market has been on steroids. In a testament to these times,
one magazine implicitly criticized Warren Buffett, who has made nothing but
money, while another lionized Jeff Bezos of Amazon.com, which has lost
ever-increasing amounts of money.
If the Fed is serious, it should send an unambiguous message to investors that
excessive speculation is unwelcome. It should raise margin requirements and
interest rates immediately with a clear warning that more increases will come
in the future if this speculation persists. It is better to accept moderate pain
now and reintroduce a sense of risk to the marketplace than to wait until a
massive blowoff and subsequent collapse occur that could severely damage
this nation for years.
--------------
DAVID ROCKER is general partner of Rocker Partners. |
