Irrational Exuberance Five Years Later

Greenspan's long-ago warning still rings true. Is Anyone listening?

We recently marked the fifth anniversary of the peak of the great millennial stock market Bubble. What were you doing on that faithful day? Were you a bull or a bear? Rich or otherwise? What about today? Have you protected yourself against the new alleged sure things? Or perhaps you believe in the permanent hegemony of the dollar in the world's currency markets? In the inevitability of rising house prices? Or in perennial low interest rates? Answer true or false: The chairman of the Federal Reserve Board is clairvoyant.

From the March 2000 top to the October 2002 trough, the U.S. stock market gave up more than half of its value, some $9.2 trillion. Five years ago Cisco Systems was the world's biggest company by market capitalization. Its line of business, computer networking, was universally heralded as the industry of the future. Owners of Cisco still devoutly believe this still to be true. Never the less they have lost 75 percent of their investment.

Americans hate to lose, especially when it comes to money, and they've demanded an accounting of the misdeeds of the bubble era. A certain number of former chief executives, like Bernard Ebbers of WorldCom, and Martha Stewart have had to pay the price for their alleged misdeeds. And Congress, in its infinite wisdom, has overhauled and stiffened the nation's reporting and securities laws.( They may be killing the Goose that lays the Golden Eggs, they have tried that before but likely have not succeeded - so far ) And yet, the chairman, governors and staff of the Federal Reserve have yet to be called to account. Will they ever?

Booms and busts are recurrent throughout history. In not every episode was there a culpable central bank. But in virtually every case, there was a Debasing of the Currency.

The enviable sight of a neighbor getting rich in the stock market in the late 1990s made millions of Americans lose their good common sense; Buying wholesale and Shopping at Wal-Mart, they would pay never pay full retail. Investing in the stock market, however, they would pay nothing but premium over retail; the larger the premium the better the deal. By the late 1990s, stocks had lost any connection to the value of their underlying businesses. That was Wall Street only five years ago. It may even still be even if to a somewhat lesser extent Wall Street today.

The Federal Reserve did not stand idly by after the bubble burst. It radically reduced the FED Funds Rate, pushing it from 6.5 percent in May 2000 to 1 percent by June 2003.

Alan Greenspan, the chairman of the Fed, had worried about a stock market bubble as early as 1995 and had warned against "irrational exuberance" in 1996, and batted around the possibility that there might, indeed, be a stock-market bubble in discussions with his Federal Reserve colleagues as late as 1999. But he was not the man to stick a pin in the bubble.

Indeed, he himself became a vociferous booster of the "New Economy." In a speech he gave only four days before the Nasdaq touched its high, he sounded as if he were working for Merrill Lynch, cheering that "the capital spending boom is still going strong."

"Should the boom turn to bust," the chairman had testified before Congress less than a year before, the Fed would "mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion." In so many words, Greenspan promised that the Fed would make money cheaper and more plentiful than it would otherwise be; Providing a PUT to speculators. He would override the market's judgment with his own."

Nobody in earshot quoted the words of the German central banker Hjalmar Schacht, who protested in 1927: "Don't give me a low rate. Give me a true rate, and then I shall know how to put my house in order." Someone should have been listening then and someone should be listening NOW.

Interest rates are the traffic lights of a market economy.

To investors, they signal when and where to go and when to stop. To individuals they dictate present vs. future consumption.(savings). With what savers can earn in interest today is there any wonder why our national savings rate is only 1%. To entrepreneurs they signal which investments are not worthwhile making. Under the Fed's bubble recovery program, every interest-rate light turned green. Go forth and Speculate is the FED's message.

With no lights flashing red or even amber, investors sped through the financial intersections ignoring any potential warning signs. They paid more for houses, office buildings and junk bonds than they would have if interest rates were not hugging 40-year lows.

The proliferation of dollars helped to lift the stock market out of its doldrums - though the doldrums of 2002 were singularly shallow in comparison to previous bear market lows. But bargains were scarce on the ground (by March 2000, stocks were uniquely overvalued; never before had a dollar of corporate earnings been so costly to buy).

At the checkout counter, inflation was well-nigh invisible. On Wall Street, however, it was - and still is - on the rise, reaching for the stratosphere. To hear Greenspan tell it in 1999, post-bubble damage control was as simple as cutting interest rates. He passed lightly over the possible consequences of the rates he cut.

The list so far includes a booming bubble-like housing market, an overheated debt market (this one spans the globe) and a steady depreciation in the foreign exchange value of the dollar.

Consuming much more than it produces, the United States emits hundreds of billions of greenbacks into the world's payment stream every year - about $600 billion in 2004 and 2005 looks like it will be in the neighborhood of $750 billion. The recipients of these dollars willingly invest them in American assets if the price is right. On the evidence of the dollar's decline, the price - the available rate of return - is too low.

Ultra-low interest rates not only serve to inflate the value of bonds, stocks and real estate. They also entice investors in those assets to employ the elixir called "leverage." Leverage means debt. Borrowing at 2.5 percent, a speculator can invest at 3 percent and still make a handsome living -as long as they can be sure when 2.5 percent might be raised to 2.75 percent or 3 percent. The Fed is happy to oblige. Forswearing the element of surprise in its policy actions, it has told the market exactly what it proposes to do. Paying close attention, professional investors, including thousands of hedge funds, have borrowed and speculated fearlessly. A little fear would greatly improve the quality of financial stewardship.

"A stock well bought is half sold," said the old Wall Street adage. What that means is that success in investing depends on one's entry price.

As Congress debates an overhaul of Social Security to permit tax-advantaged saving by millions of new investors, a passage from the new Berkshire Hathaway annual report warrants attention.

"We don't enjoy sitting on $43 billion of cash equivalents that are earning paltry returns," writes Warren Buffett, Berkshire's chairman. "Instead, we yearn to buy more fractional interests similar to those we now own or - better still - more large businesses outright. We will do either, however, only when purchases can be made at prices that offer us the prospect of a reasonable return on our investment."

Greenspan in his latest speeches is once again warning about "irrational exuberance"! The words are different but the meaning is still clear. but ounce again he is doing almost nothing about it except attempting to warn everyone, by his succession of ¼ point interest rates rise, of the looming danger, while at the same time continues to fuel the fires by constant increases in the money supply. He is trying to engineer a soft landing by hoping that everyone will see the light and heed his words instead of the FED's actions and curtail their Irrational Exuberance". "Do as I say Not as I Do" He seems more interested in protecting his legacy than in protecting the country.

But alas the bubbles keep on expanding and they will end like every bubble has ended in the past.

HISTORY REPEATS

The 1920's Bubble came to an end when interest rates rose high enough to create a liquidity crises and even though Hoover had interest rates lowered from 6.5% down to 1.5% in less than a year. Then like in 2000 once started there was no reversing the burst bubble (you can't unscramble an egg or repair a burst Bubble). But unlike 1919 when Hoover was only Secretary of Commerce he was now the President and where President Harding refused to go along with his hair brained socialist schemes to fight the depression and did nothing. " the Banks got themselves into this mess so let them get themselves out" was Harding's fervent reply and so the depression lasted less than two years even though the 1919 economic deflation was much worse than the 1929 one. But alas in 1929 Hoover was now President and he was able to implement all his socialist ideas to fight the depression. By this time there was now a FED and so he lowered interest rates, started make work projects such as the building of the Hoover Dam and the TVA and in reality was the father of the NEW DEAL. Being in a depression the Republicans were naturally swept out of .office and FDR and the Democrats took over in 1933 and promptly expanded Hoover's actions into the NEW DEAL which rather than end the depression actually extended it for another 14 more years.

By 2006 we should be in recession and the Republican will lose at least one of if not both the houses of Congress…and by 2008 the USA will be in depression and Hillary will win in a landslide, and become the FDR of the 21st Century. Like FDR before her, and being a good socialist with full control of both houses of Congress, she will promptly reverse the Bush Tax Cuts +, as well as institute a series new deal type legislation. If all that weren't enough a 21st century Smooth Holley Bill if not already passed would soon be.( there are already 80 anti-trade bill working their way through congress) Put it all together and this coming Depression will take over from the 1930's as being the worst depression in American history

Conclusion

If you have never gone short then don't start now, unless you can find an expert advisor. Just buy US short term Treasuries (five years or less) Buy Gold and Wear Diamonds. You can also accumulate silver on dips.

GOD I HOPE I'M WRONG

Aubie Baltin CFA, CTA, CFP, Phd. (retired)
Palm Beach Gardens, FL
[email protected]
561-840-9767

5 September 2005