July 21, 2003
Dow Jones Average: 9,188
S&P 500 Index: 992
Greenspan's Legacy
In testimony before Congress, Federal Reserve Board Chairman Alan
Greenspan has frequently warned against government giving investors implied protection
from market risks. When investors feel insulated from risk they tend
to become far more aggressive. Even as Greenspan worried publicly
about "irrational exuberance" in the markets his own actions
encouraged speculation. A mystique grew around Alan Greenspan in the
late 1980's and the 1990's. He was seen as the man who understood
how to fine tune the economy, prevent recessions, and use monetary
policy to rescue the financial markets from any unpleasant declines.
Investors came to believe that they couldn't lose as long as
Greenspan was in charge. It is ironic that his efforts to keep everything
in balance, to avoid economic downturns at all cost, have contributed
to some of the greatest extremes in the history of financial markets.The
cult of Alan Greenspan, revered as the man who would always rescue
the financial markets, has led many to take greater risks than they
otherwise would have taken.
Greenspan's legacy is one of dramatic interest rate cuts designed
to restore investor confidence in financial markets. While these interest
rate cuts stabilized the markets in the short run, they contributed
to a cycle of financial excess. As the newly elected Fed Chairman
in 1987, Alan Greenspan was greeted by the stunning stock market collapse
in October of that year. His reaction was to immediately cut interest
rates by several percentage points and issue a statement that the
Fed would provide all the liquidity (cash) necessary to stabilize
banks, brokerage firms, and the markets. While the lower rates may
have prevented further losses on Wall Street, they most certainly
helped fuel a speculative real estate boom that crested in 1989-1990.
Throughout the 1990's the same pattern persisted, with Greenspan slashing
rates to rescue the market in 1991and 1998. The market's normal defenses
against excessive risk taking were weakened as Greenspan administered
his interest rate medicine. Risk taking ran wild producing the greatest
stock market bubble in U.S. market history.
In the past few years Dr. Greenspan has cut interest rates thirteen
straight times in an effort to revive the markets and economy from
a post bubble malaise. With short term interest rates at sixty year
lows of one percent and the economy still languishing, it appeared
to many that the doctor was out of remedies. But on May 6th of this
year Greenspan tried a new tactic, claiming that he was concerned
about the possibility of deflation and was prepared to take extraordinary
measures to prevent its occurrence. The unusual measures would include
active buying of longer term treasury bonds by the Federal Reserve
Bank. The Federal Reserve controls only the short-term funds rate
that currently hovers around one percent. Longer-term bond rates that
are near five percent are the result of buy and sell decisions made
by millions of investors worldwide. While the Federal Reserve has
no direct control over longer term rates, Greenspan's comments suggesting
possible government intervention in the bond market caused a buying
stampede in longer term bonds and a spillover effect that buoyed stock
prices as well.
We think that the markets would be better off if they were allowed
to find their own level without constant interference by government
officials such as Mr. Greenspan. His comments on deflation, repeated
on a weekly basis in May and June of this year, were always qualified
by his assertion that deflation was a minor, miniscule, remote possibility.
We wonder why the highest ranking financial official in the nation
found it so necessary to repeatedly discuss a scenario that was so
unlikely to occur. The net effect was that investors, already desperate
for some yield on their money, overpaid for longer-term bonds on the
mistaken assumption that the Fed would support the value of bonds.
Once again Alan Greenspan was viewed as the guarantor of aggressive,
ill-advised investment decisions.
Current Strategy
Stock prices rose in the latest quarter, as some investors grew
more optimistic about economic growth and corporate profitability.
Bond prices also moved higher driven by Chairman Greenspan's comments
on deflation. While investors welcomed an up quarter for a change,
few seemed concerned that the two scenarios propelling stock and bond
prices are totally incompatible. The last time deflation hit the United
States the country was mired in the depression of the 1930's. Deflation
may enhance the attractiveness of government bonds, but it would be
ruinous to corporate profits and the stock market. When the markets
become irrational, as they did in the latest quarter, we either take
some gains off the table or stand aside in money funds and short-term
treasury bills.
The stocks that gained the most during the past quarter were the
sickest companies in weak industries. Companies with stronger businesses
and higher stock prices such as Johnson & Johnson, New York Times,
IBM, and Microsoft were either down or flat in price over the past
few months. The top two performers of the Dow Jones 30 stocks were
McDonalds and Altria (the new name for Philip Morris). Both companies
had previously been falling due to slow sales, public health issues,
and lawsuits. Airlines and companies with asbestos exposure also experienced
strong recoveries in the second quarter of the year. It seemed that
the closer a company was to bankruptcy the better it did from a percentage
standpoint in the latest quarter. We found few stocks that attracted
us in this environment. We will be more interested in stocks when
higher quality companies with good balance sheets sell for lower prices.
Bonds became ridiculously expensive during the quarter as many investors
were panicked into paying high prices by Greenspan's deflation
warnings. We stood clear of the bond market stampede, opting instead
for five-month treasury bills that change little in price and come
due quickly at full value. Since quarter end, bond prices have fallen
sharply and interest rates have risen as Greenspan downplayed his
deflation concerns in his July congressional testimony. Investors
who acted on his comments last quarter were blindsided by his change
of emphasis from deflation to faster economic growth. Now that interest
rates have spiked higher we are switching a portion of our client's
capital from treasury bills to bonds with longer maturities.
