Here's an op-ed piece related to the subject of a rescue by the FED from today's WSJ by Yale economist Shiller, who gets bashed a lot. However, everything I've read by him has seemed pretty insightful. Can't post a link because subscription required.
--QS
The Fed Can't Prop Up The Falling Markets
By Robert J. Shiller, a professor of economics at Yale's International Center of Finance and author of "Irrational Exuberance" (Princeton University Press, 2000).
Over the past half-dozen years, the U.S. stock market has demonstrated as classic a speculative bubble-and-burst pattern as any in history.
The Nasdaq Stock Market smoothly rose sixfold to a record high over the five years ending March 10, 2000, and has now dropped more than 60%. The Standard & Poor's 500 smoothly rose threefold to a record high over the five years ending March 24, 2000, and now has dropped more than 20%. To find another bubble-and-burst example as clear as this, one would have to go back to the tripling of the S&P Composite over the five years ending September 1929, and the subsequent 34% decline to September 1930.
The cause of the recent pattern of increase and decline is largely the same as in all speculative bubbles: public overreaction, both up and down, because of a feedback mechanism.
When prices are increasing quickly, there is upward feedback. Public attention is drawn to the price increases, expectations and confidence increase, demand for stocks rises, and the increased demand causes stock prices to rise then again. Part of the feedback mechanism also operates through general business conditions: Increasing expectations and confidence about the stock market encourages people to spend more on goods and services, thereby propelling upward the general economy, and hence corporate profits. This, in turn, propels upward the stock market, again boosting confidence and expectations.
When stock prices no longer increase, the process stops. And when prices decrease, downward feedback begins. Price declines generate lowered expectations and heightened worries and demand for stocks falls, causing stock prices to fall again.
Many people find feedback stories implausible since they imply that stock-price increases are steady and uninterrupted upward from day to day during the increase, and then steady and uninterrupted downward from day to day during the decrease. In fact, we know that prices jump around erratically from day to day.
But, the bubble theory doesn't in fact imply such steady price increases and decreases, since there is a lot of noise in the market and reactions to price changes aren't just to yesterday's price change but to the run of price changes over years.
Other people find feedback stories implausible since they imply that there is a large profit opportunity to betting against the bubble, too good to be true. There is in fact a profit opportunity to doing so, but the bet is no sure thing and isn't usually available. Classic bubble-and-burst patterns are actually quite rare in history, because it is unusual that supporting factors allow the bubble to continue for so long.
The confluence of a number of factors over the past decade contributed to public demand for stocks and hence the enormity of the price increases from 1995 to 2000. These include: the appearance of the Internet, and the myth that it would be a historically transforming event; the Republican Congress and pro-market public policy; the rise of an entrepreneurial as well as a gambling mentality; baby boomers reaching middle age; the expansion of media coverage of business news; the increasingly optimistic forecasts of analysts; the expansion of 401(k) plans; the growth of mutual funds; the continued decline of inflation; and the enthusiasm for the future brought on by the new millennium.
These factors, and the feedback they generated, left the markets at extraordinarily high levels. No bad news is necessary for the bubble to burst, merely the absence of further increases in good news. The market appears to have overreacted to the small earnings declines of the past few quarters; in fact, the overreaction is just part of the natural process of a bubble eventually bursting.
So much of today's market rhetoric revolves around the actions of Federal Reserve Chairman Alan Greenspan. People are hoping the actions of the Fed at its next meeting on Tuesday will be enough to restore our bull market. This rhetoric often seems to have economic theory on its side. After all, the interest rate is the return on bonds -- a competitor for stocks as investments -- and ought to affect the rate at which expected future dividends are discounted into today's price.
But, if markets were efficient, as most economic theory claims, then the positive effects of an interest-cut change on the stock market should occur entirely on the day of the change, or all of a sudden. In truth, the one-day effects of Fed policy changes have almost never been big enough to make much difference to the market.
The exception to this rule is the record 14% increase in the Nasdaq on Jan. 3, which came on the back of the Fed's first rate cut this year (after a series of rate hikes ending last summer). The intensity of that reaction shows that the market has become much more responsive to Fed actions. But, it doesn't give much reason to think that a continuation of rate cuts will reverse the slide. (Nasdaq lost all of its Jan. 3 gains by Feb. 21.)
The question remains: Is the bubble fully burst, or is it still on its way down? There are no certainties here, but one must recall that the market is still quite high. The S&P still has a price-earnings ratio of 24, compared to a historical average from 1871 to 1995 of 14. The Nasdaq still has a price-earnings ratio of 163, compared to a historical average since 1985 of 52. There is a good chance that the market is still heading down, or at least will stagnate at roughly current levels.
And the Fed, no matter how much we might hope, simply doesn't have the power to bring it back up again. |
