Fair use etc...The q factor
By David Warsh, Globe Staff, 5/14/2000
ne of the tantalizing mysteries of the day has to do with why Alan Greenspan accepted appointment to a fourth term as chairman of the Federal Reserve Board. His third four-year term expires in June. Then the 74-year old banker will be sworn again.
Why bother? Greenspan has presided over the greatest bull market in history. He took office in August 1987, just two months before the October stock market crash drove the Dow Jones industrial average to a hard-to-remember 1739.
He was reappointed by President Bush at the end of a mild recession in 1991 that most people believe cost Bush his presidency. President Clinton struck an initial bargain with Greenspan but reappointed him in 1995 only with reluctance. The Dow was at 5500 then; it is nearly twice as high today. Surely his place in history is secure.
Or is it? Perhaps Greenspan figures that no one has a better chance than he does of cleaning up the potential mess he's made.
''Over the past five years or so the Fed has knowingly permitted the development of the greatest asset bubble of the twentieth century.''
That's the gravamen of a new book by Andrew Smithers and Stephen Wright, ''Valuing Wall Street: Protecting Wealth in Turbulent Markets.'' The authors are prominent English invesment advisers, who base their analysis on the well-known ratio between share prices and the replacement costs of underlying assets, known among economists as q.
Smithers and Wright maintain that the Fed should have raised interest rates in 1995, when the stock market first began to be noticeably overvalued by conventional measures, in the wake of the Mexican peso crisis. That might well have caused a mild recession in 1996, they say, ''but it would probably have saved the world from a really deep one early in the new millennium.''
True, they say, an aggressive tightening in 1995 might well have cost Greenspan his job, and Clinton the 1996 election. About these perils they are philosophical. ''It takes a great deal of leadership to accept such risks and try to persuade voters to accept the short-term pain for their longer-term reward.''
Instead, Greenspan and his board conducted monetary policy along gentler lines. The market (measured by the Dow Jones industrial average) surged 33 percent in 1995 and 27 percent in 1996.
With the Dow at 6400 in December 1996, Greenspan gave his famous ''irrational exuberance'' speech. ''How do we know when irrational exuberance has unduly escalated asset values? ... And how do we factor that assessment into monetary policy?''
Once again, the market rose - yet another 30 percent in the first half of 1997, before the Asian financial crisis put a distinct chill in the air. The American economy remained strong, and the Asian economies recovered, thanks in large measure to the strength of their exports to the United States. Starting in late 1998, the stock market once again resumed its upward march.
Last summer Greenspan formally renounced his earlier skepticism - at least the highly public stance. At a Federal Reserve conference at Jackson Hole, Wyo., he genuflected to a stock market that he said reflected the ''judgments of millions of investors, many of whom are highly knowledgeable about the prospects for specific companies that make up our broad stock price indexes.''
The market - the technology-rich Nasdaq Composite index in particular - responded by going through the roof.
Andrew Smithers is a prominent doubter. After taking a degree in economics at Cambridge University in 1959, he worked in London for a development bank for a couple of years, then joined S.G. Warburg Co. as an institutional money manager. There he helped build its private pension business from $20 million to $40 billion, largely at the expense of English insurance companies.
After 27 years at Warburg, Smithers took three years off to live in Japan (during the period of its bubble), then formed Smithers & Co. to offer advice to institutional money management companies. Soon he had 80 clients, including several large Japanese firms. His work in 1998 on the tendency of stock options to cause earnings to be overstated was particularly influential. He writes a weekly column for London's Evening Standard. Strategist Barton Biggs calls him ''one of the five best, most dispassionate, erudite analysts in the world.''
Unlike other bears such as Robert Shiller of Yale University and John Campbell of Harvard University, who base their conclusions on the analysis of price-earnings ratios, Smithers and Wright prefer a framework rooted in the economic concept known as q.
There is nothing especially complicated about q, they say, although it is capable of great economic elaboration. Basically it reflects the tradeoffs inherent in any make-or-buy decision. Formally broached by Yale economist James Tobin in 1969, q is the ratio between stock market value and net worth, meaning the book value of physical and financial assets minus liabilities. The Federal Reserve publishes the most widely used estimates as part of its ''Flow of Funds Accounts of the United States.''
The idea is this: When stock prices rise in relation to replacement costs, q has a high value. Investors spend heavily on plants and capacity then and save little; the profusion of real assets causes the rate of real returns to capital to fall. Stock prices in due course fall to reflect that lower rate of return; then q falls to its historical average. When q is very high with respect to its historical average, it means that stocks are unrealistically high. Q.E.D.: The 11,000 Dow is a bubble.
(The authors note that q-watching entails an investment strategy as well. Adepts who buy when q is low and sell when q is high - as it is now - can hold more stocks for longer than investors who pursue a strategy of buy-and-hold or, for that matter, index-fund investors. Indeed, Smithers and Wright's book contains a good deal of self-help for sophisticated individual investors.)
The q argument is not unknown to Alan Greenspan, any more than are the charts showing price-earnings ratios at Himalayan heights. He may in fact have changed his communications strategy more than his underlying views. Pricking a bubble may yet require something more than sharp words.
So on Tuesday the chairman must preside over a meeting of the Federal Open Market Committee, at which further monetary tightening is expected - perhaps as much as half a point on short-term interest rates. Next month Greenspan is slated to begin another four years as chief.
He is generally not expected to finish his term. His goal must be to engineer yet another soft landing, in this case a little harder than the rest - a short, sharp recession to redress the imbalances that have built up in the last several years. Once the coast is clear, Greenspan is expected to leave - to allow the next president to appoint a successor and take the responsibility for the next several years. Then, and only then, will his work be done.
Says Smithers, ''One of the interesting features of the next two or three years will be the events that tell whether the consensus view or the dissenting view of Alan Greenspan was right.'' We are, he concludes, ''about to live in interesting times.''
This story ran on page H1 of the Boston Globe on 5/14/2000.
¸ Copyright 2000 Globe Newspaper Company.
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