Bermuda: Greenspan’s Optimism and Worries
LOM Weekly Perspectives

At the time of Greenspan’s "irrational exuberance" comment, in 1996, some concerned analysts were juxtaposing charts of U.S. stock-market indices and the Nikkei 225 and drawing worried conclusions about future market prospects. These worrywarts were entirely ignored for the next couple of years because everybody was in a partying mood. Notable among the fun lovers was the Chairman of the Fed who contributed by providing plenty of liquidity for the collective punch bowl and talking extravagantly about the "new economy". Alas, such overindulgence has also resulted in an extended hangover.

Would you believe it that some Fed officials are now quietly doing the same stock-market comparisons and the fit between the two series is even better than before. They are also carefully examining Japan’s policy responses after their bubble burst, as an aid to formulating appropriate policies to forestall a repeat performance of the Japanese experience in the United States. However, this wasn’t something that Greenspan wanted to talk about in his testimony before Congress, last week. Instead, he iterated all the required melodious words to help boost investor and consumer confidence. Meanwhile, every notable official and his retinue are doing their bit to calm investors' jangled nerves.

Recent data on mutual fund flows provides further indication that the patience of some retail investors has run its course and they are now throwing in the towel. At the same time, there aren’t a lot of buyers ready to jump in from the sidelines. The mantra " buy on the dips" is no longer on the lips of the faithful. Indeed, it appears that some folk have lost their faith entirely. Too many Wall Street types have in the past few months repeatedly signalled that the bottom of the market has been reached, only for the indices to subsequently reach for even lower depths. There is an old saying that if there are too many declarations of the bottom having been reached, then there is a high probability that we are not actually there, yet.

It was always a question of whether valuations would go nowhere for a long time until earnings growth came back to justify them, or that they would fall sharply until they became cheap enough in terms of realistic earnings-growth prospects to attract more buyers. Currently, potential sideline buyers do not believe that valuations are such that they need to be panicked into buying. Apparently, they do not feel confident in calling a bottom and are not particularly fearful of missing it, figuring that there will be enough time to participate in a bull market if it develops. Meanwhile, there is a lot of volatility, even as the market trends lower, due to hedge fund activity and program trading.

Many people are saying that it’s just a stock market problem and the economy is doing fine. If only the world was so nicely dichotomised. We would then simply wait for the stock market to catch up with the economy. Unfortunately, they are part of the same system with a lot of interaction between them. Right now, the data on economic activity paints a reasonably positive picture. But the stock market is supposed to be forward looking and skilful at making an assessment of how things are likely to turn out in 2003. On the evidence of the selling pressure, the collective mind of the market does not like what it sees. Quite apart from the accounting and corporate governance issues, there are problems associated with corporate debt loads, pricing power and profitability, as well as the current account deficit. In addition, there is a legitimate question of how long consumer spending can hold up in the face of falling stock prices.

One of our themes has always been that there are imbalances in the U.S. economy that need time to adjust, and there are no quick fixes. The problem for policymakers, right now, is to prevent a slip from turning into an extended slide, similar to Japan. And chances are still good that such a fate will be avoided. As we all know, the Fed did the right thing from the start - - in this easing cycle - - cutting interest rates early and massively. Currently, we are at a stage where, in terms of core inflation, the fed-funds rate is actually negative. However, more weakness in the equity market may, in turn, prompt authorities to engage in a further interest rate reduction to arrest declining confidence. A modest 25 basis-point cut will not achieve a great deal and there is a danger that it may be interpreted as signalling unknown systemic problems in the financial system. Also, the Fed needs to keep ammunition aside in case it is needed more badly later on. With the fed-funds rate currently at 1.75% it doesn't have a lot of this sort of ammo left.

Another more direct way is for the Fed to lean on banks to ease credit conditions for ultimate borrowers, particularly corporations. This is a delicate matter because it would compromise the normal risk-taking calculations that profit-maximising banks make. It would expose them to greater risk than they would normally accept. There is also the moral hazard issue of bailing out entities that have taken wrong decisions and assumed too much risk. Saving them is a contradiction of market-oriented solutions and introduces distortions into the normal operation of the economic system. However, if the situation deteriorates it would be better to take distorting action rather than to stand still. Nobody wants to go through anything resembling the Japanese experience.