We should Fight the Fed???-----As you Know we must consider all sides of this Elephant also known as the Global
MacroEconomic Environment know that we are truly in the 3rd Millenium. And of course the US Equity market,
has arguably as much impact around the world as any other market, these days.
here is a very interesting article by Marshall Auerback........
AN INSTITUTIONALISED MANIA:
WHY YOU OUGHT TO FIGHT THE FED
May 15, 2001
Now that the rate cutting season is well and truly upon us, predictably Wall
Street’s visionaries have begun to utter the classic truism in support of
equities despite continued problematic valuations: "Don’t fight the Fed."
This slogan is predicated on the notion that the US monetary authorities
have begun to cut rates and reflate aggressively over the past few months
and that such aggressive action will ultimately engender the "V"-shaped
recovery required to sustain current stock market valuations. In this
context, argue the bulls, liquidity overwhelms fundamentals. Even
long-term, dispassionate bears such as market technician James Stack
have made the point that since most monetary measures are currently
running at "the highest level since the hyper-inflation of the 1970s,"
investors ought to "stay in step with the technical/monetary evidence and
ignore fundamentals because they’re going to get a lot worse!" In our
analysis of the current mania, however, we have persistently argued that
we have not been experiencing a typical business cycle, but an asset
bubble long pumped up by ever growing quantities of credit and therefore
increasingly less responsive to repeated interest rate cuts. Simply paying
heed to hyper monetary inflation in our view is akin to treating a patient
with drugs that were the cause of the initial illness. We are now in the
midst of a capital goods recession; capital expenditure, particularly in high
tech, is in sharp decline. It is falling from an unprecedented lofty peak. It is
being slowed down by the sheer burden of debt and the consequent
inability to service that debt as saturation dynamics take hold
We have not
seen anything approximating this condition in the US economy since the
1930s. The most comparable post-war situation is the bubble economy of
Japan in the 1980s, during which a capital expenditure boom (also fuelled
primarily by debt) reached an unprecedented 25 per cent of GDP at its
peak (whereas during most of the post-war period, capital expenditure as a
percentage of GDP in Japan was about half this level).
The Japanese analogy is also instructive in many other ways. In the
aftermath of such excesses, the unwinding generally persists for a long
time and proves surprisingly impervious to repeated interest rate cuts.
Japan has had years of virtually zero interest rates, yet nobody hears
Japanese investors arguing today that it is fruitless to fight the Bank of
Japan in spite of the central bank’s repeated cuts in the discount rate.
Indeed, for the past few weeks, we have witnessed the unprecedented
spectacle of the Bank of Japan trying to inject hundred of millions of yen
into the banking system, and having the nation’s banks refuse to accept
these virtually free funds.
We also concede, however, that there is something unique about the
current US mania, which is unlike that of the American boom of the roaring
twenties or even Japan in the 1980s. It is the sheer institutionalisation of
this mania, which in turn casts doubt on the whole premise as to whether
one genuinely should not "fight the Fed", given that America’s monetary
authorities seem every bit as complicit in creating and sustaining the
current state of affairs as any Wall Street investment bank might be
predisposed to do. The endorsement of the current mania, and the
concomitant attempt to discredit those who question it, is to be expected
from Wall Street and the money management industry. They are in the
business of earning fees, which are directly proportional to the value of the
stocks they sell, the portfolios they manage and the corporate transactions
they undertake. In contrast, the notion of investors not fighting the Fed is
ultimately predicated on an idea of a responsible and neutral monetary
authority which, however many mistakes it may or may not make, does try
to conduct policy in an honest manner generally perceived to be in
society’s best interests, rather than a narrow coterie of speculators and
investment banks. Therefore when such supposedly disinterested
authorities do begin to conduct themselves in a way that appears to
underwrite the most egregious forms of speculation and target their
monetary policy accordingly, it is time to ask whether the old truism about
not fighting the Fed still applies.
During most speculative manias, only a minority of high-risk rollers
participate. There tends to be a mainstream scepticism of the gambling and
the revelry associated with the stock market "party". Usually risk-averse
households remain sceptical and stay away. Society’s staid elders tend to
frown. We saw this in 1928-1929 when the Federal Reserve under
Governor Benjamin Strong repeatedly warned about the dangers of stock
market speculation.
By contrast, in this bull market, despite valuations that vastly exceed those
of the peak in 1929, or those of Japan in 1989, all of society has been
onboard: a cheerleading media on CNBC, captains of finance and industry
(whose own behaviour increasingly reflects a trend of stock prices driving
corporate activity, rather than being a mere reflection of it), the Secretary
of the Treasury, the Chief Executive, and even the Chairman of the
Federal Reserve whose accounts of the technological wonders and
subsequent efficiencies of the "new era" have significantly outnumbered
his occasional misgivings about valuation. This widespread social
benediction of the bull market in stocks has led an unprecedented number
of otherwise risk averse households to commit an unprecedented
proportion of their assets to the stock market, and let the market do their
saving for them. Recognising their limitations as investors, these trusting
souls have turned to professional mutual fund managers to do their equity
market investing for them. The institutionalised character of this mania has
made possible a deeper public involvement than ever before which has
given this bull market a power that has been unprecedented in stock
market history.
It has also affected policy making of America’s monetary officials to an
unprecedented degree, as a recent Washington Post article by columnist
John Berry indicated:
"While Greenspan and other Fed officials maintain they are not in the
business of targeting stock prices, they readily acknowledge that the market
can have a significant impact on the economy and that does concern them.
For example, the weakness in the stock market over the past year is a factor
in business investment decisions because the market can be a source of
inexpensive funding for new plants and equipment.
But if investors were still driving stock prices downward -- as appeared to be
the case until the first part of April -- a surprise rate cut might have had little
impact on the market. Like an intervention in foreign exchange markets to
affect the value of a currency, officials felt it would be better to wait until the
market appeared to have hit bottom and was on its way up.
As the market began to improve during the week before the rate cut, another
factor came into play -- Easter. The market was to be closed on Friday, April
13, and was to close early the day before, and under such circumstances
trading volume is usually low. So if one goal, likely a subsidiary one, was to
give the market a boost, the following week was probably a better bet."
Berry first offers up the usual official nostrum that Greenspan and other
Fed officials are not in the business of targeting stock prices, yet then goes
into great detail describing these officials’ deliberations as to when rates
ought to be cut at a time in which the condition of the stock market
appears to play the primary role in their considerations. The final
paragraph cited above makes clear that, contrary to the initial assertions,
the Fed now does appear to be playing a role in which it actively targets
stock prices. Why worry about the Easter break and the corresponding low
trading volumes around that period, for example, if the objective was not to
give the stock market an unexpected boost? And why be so public about
these deliberations (Berry and Louis Uchitelle of the New York Times
have long been viewed as unofficial spokesmen for the Federal Reserve) if
not to send a clear, reassuring signal to investors that the Fed is in fact
there to underwrite the investing public’s losses?
Deliberating upon this new reality, Henry Kissinger, in an editorial in the
Financial Times three years ago, recognised early on that monetary policy
would now become asymmetric with regard to the stock market: it would
move aggressively to avert stock market declines but would not move in a
similar fashion to discourage stock market increases. Greenspan himself
has made this more explicit in recent times (on the bogus notion that stock
market falls tend to be more rapid and violent than rises in equities,
thereby justifying a seemingly asymmetric response to the market), and
Berry’s Washington Post article suggests that we are one stage closer to
the Fed playing the ultimate moral hazard card, whereby stock prices are
explicitly supported by the monetary authorities. But as we have noted on
numerous occasions, when the stock market is seen as too big to fail and
policy is seen to be asymmetric, thereby fostering a possible upward
ratcheting in valuations, a new and perhaps more dangerous moral hazard
arises. Many investors now perceive that the Fed has fallen into such a
policy trap and have consequently gone cynically long the stock market
regardless of valuations. In fact, they have gone long the stock market
regardless of economic and profit declines.
Global strategist Frank Veneroso notes a most interesting precedent for
this type of moral hazard. The most extraordinary market bubble of all
human history was the stock market bubble in the Persian Gulf in the late
1970’s and early 1980’s which he observed first-hand as an advisor for the
World Bank. This bubble started with speculation on the Kuwait stock
exchange and ended with an unbelievable speculative mania on an over the
counter market in Kuwait City called the Souk al Manakh that traded
largely fraudulent companies domiciled in the United Arab Emirates.
Because the wealthy citizens of Kuwait that invested on the Kuwaiti stock
exchange were "brethren" of the Sheik of Kuwait, the government
intervened to stop a severe crash in a very overvalued market in 1977 and
again in 1980. According to Veneroso, this gave rise to a widespread belief
that the Kuwait stock market was too important to fail and a corresponding
belief that it was pointless fighting the trend. The unprecedented
speculation and inevitable disaster that followed would not have occurred
had there been no moral hazard created by government intervention to bail
out Kuwait stock market speculators.
The lesson of the Souk al Manakh is clear. If the Fed continues to foster
beliefs that the stock market is too big to fail, there is a risk of unbridled
speculation that will encourage households to bid stocks ever higher and
force herding relative performance money managers to stay on board
regardless of fundamental developments. This perceived "safe haven" bid
in the market in part explains why the fall in the stock market has been
coincident with the slowdown in economic activity, rather than a leading
indicator (as is usually the case). In Japan, the market plunged by 50 per
cent in 1990, but the economy did not enter recession until early 1991; the
stock market proved to be an accurate leading indicator for the real
economy. The real economy of the United States, by contrast, has not been
buttressed by the Greenspan put in the manner in which stock prices have
been, which in part explains the market’s delayed reaction to a
deteriorating macroeconomic backdrop last year. However, the corollary
also applies: as an apparently coincident, as opposed to lead, indicator, it is
also difficult to determine the extent to which the market truly has
discounted the "valley" of bad profits witnessed over the past few
quarters.
The authorities would probably like to see the stock market stabilize on a
permanently high plateau, but speculations fuelled by moral hazard are
dynamic systems that tend to go parabolic and then crash. Stresses are
already showing up in the credit markets: despite 250 basis points of ease
since the beginning of the year, bond yields have risen some 50 basis
points from levels prevailing at the beginning of this year. Even the
statistical sleight-of-hand that constitutes the current measure of consumer
price inflation is at a nine-year high and the GDP implicit price deflator is at
a five-year peak. The credit markets clearly recognise the nature of
Greenspan’s reckless game even if equity investors do not as yet. There is
also growing evidence that the declines sustained thus far in the tech-laden
NASDAQ and overall sideways action of the Dow Jones is in fact causing
the more risk averse household investors who invest primarily through
mutual funds to revise downward their expectations for future returns to
stocks and raise their preference for liquid assets. The past few months
have seen fund outflows for the first time in years.
In purely speculative markets past returns determine expected future
returns. What one does not know is the time lag between changes in past
performance and changes in expected future returns. Because of the deep
societal support for stock speculation and the apparent "professional"
nature of the mutual fund management of household commitments to
equities, after an almost two decade long bull market one could presume
that household expectations regarding expected future returns to stocks
would fall fairly slowly, which helps to explain the persistently positive
sentiment readings one observes, despite the massive carnage sustained
in most portfolios since the beginning of the year. This suggests that the
recent rebound in the US stock market despite profit erosion and still high
risk spreads in credit markets is attributable to a long lag between
decelerating stock prices and eventual downward revisions to expected
future returns. But the Fed apparently believes that it cannot afford to
allow such expectations to ratchet downward as this might trigger the crash
dynamics that would destroy consumption, and eliminate the last
underpinnings for the economy as a whole. Which at least provides some
rationale for the Fed’s persistent, albeit misguided, targeting of stock
prices. They seem to operate as if shifting stock prices higher will help to
buttress consumption, investment and corporate profitability, by elevating
expectations, rather than adopting policies to alleviate current imbalances
in the real economy, the correction of which would ultimately allow for a
more sustainable rise in stock prices. But even though the Fed has gone
through Alice's looking glass, leaving the familiar world behind, it does not
follow that we have to go along blindly, seduced by the notion of not
fighting this supposedly omniscient, "market-neutral" institution. To
simply follow Alan Greenspan along unquestioningly might ultimately leave
investors in a position comparable to the rats and children who merrily
followed Browning’s Pied Piper out of the village of Hamelin and off a cliff,
never to be seen again. |
