Greenspan
Versus
Main Street and Wall Street
by Alexander Paris, editor
The Alexander Paris Report
Alan Greenspan may soon start feeling as lonely as the Maytag repairman if he raises interest rates a few more times, which it appears he is determined to do. He has already come under criticism by many for trying to slow the good times of our long Goldilocks economic expansion when the consumer price index remains so well behaved. But, in an in-your-face fashion, despite four interest rate increases, consumers have continued to spend with abandon. Driven by the consumer, fourth quarter GDP growth sizzled with a 6.9% surge and now the industrial sector is coming to life as well. More recently, Greenspan has come out of the stock market closet in recent testimony before the House and then the Senate and may soon add Wall Street to his list of critics. While reluctant in the past to admit he would like to slow down the stock market, for fear of being charged with manipulating it, he clearly put it on the table in his testimony. In no uncertain terms, he singled out the rising stock market as playing a key role in creating potentially inflationary excess demand and stated an intention to squeeze inflation out of the economy by bringing the growth in asset values in line with the growth in income. We agree with most of Greenspan's reasoning, but it may be time for new weapons.
Greenspan Out of the Closet
We don't believe Greenspan's warning to the stock market could be much clearer. He really wants to cool the stock market off, and, this time, is doing something about it aside from talking about irrational exuberance. Now he is saying that the point is not whether stocks are overvalued, but that they are unduly affecting the economy and the outlook. He is talking about rising commodity prices and tightening labor conditions. What is different about his recent comments is the new focus on the stock market.
The Wealth Effect
Though
mentioning it often in the past, Greenspan is now going into
much greater detail about the wealth effect, describing
how rising stock prices and market value of assets held by households
were creating additional purchasing power for which no additional
goods and services have yet been produced. His testimony
is peppered with quotable comments on the phenomenon, such as,
The sharp rise in consumer outlays relative to disposable
incomes in recent years, and the corresponding fall in the saving
rate, has been consistent with this so-called wealth effect on
household purchases.
He even unveiled
an indicator he tracks relative to the wealth effect, the ratio
of household wealth to disposable income. Using income as a proxy
for growth in the company's productive capacity, he reasons that
a rising gap in the growth in wealth over income is equivalent
to a growing gap in demand over supply. The ratio did not change
much from 1988 to 1996, ranging between 4.8 and 5.1 times. But
it rose to 5.7 in 1997, 6.3 in 1999 and is heading toward 7.0
times.
The
point is that a part of that growing wealth is spent and consumers
are saving much less out of their incomes. The Fed estimates
that three to four cents out of each dollar of stock market wealth
is spent. That doesn't seem like much, but when multiplied times
the trillions of dollars of new stock market wealth, it adds
up to big figures, even by Washington standards.
We have seen other
studies estimating this wealth effect 7% to 8%. No one knows
what the figure is for sure and it may be greater at some times
than others. With record magnitude and length of the bull market,
it should be safe to assume that the wealth effect is much larger
than usual. There is, in our opinion, plenty of anecdotal evidence
to this conclusion. Greenspan has estimated that the stock market
has added a full percentage point to annual GDP growth over the
last five years.
The concern is that
this excess wealth-based demand is not being fully met by supply,
even with rising productivity. It is argued that the rise in
productivity is leading to higher expectations for corporate
earnings, higher stock prices, increases in household assets
and higher purchasing power for which no additional goods and
services have been produced. That is, the increase in consumption
is more than offsetting the increase in supply from productivity
gains.
Household Equity Holdings
We also continue to see more studies and evidence of the potential wealth effect on consumer spending from asset values. This should make Greenspan all the more likely to search for new says of cooling the market speculation. Merrill Lynch recently pointed out that equities (defined as stocks, mutual funds, bank personal trusts, defined contract pension plans and state and local pension funds) have now passed real estate in household assets. Equities grew at a 25% compound rate from 1995 through 1999. The Fed estimated that the stock market accounted for 25% of GDP growth over that period and that consumers tend to spend 3%-4% of stock market wealth, compared to 5% of real estate wealth. We suspect that the wealth effect of equities has been higher than that recently due to the extended nature of the bull market, the strong spending on consumer durables and housing so late in the cycle, and the extreme decline in the saving rate. We also believe that the wealth factor from equities has played a role in the bidding up of home prices. Mortgage refinancing is a major way that consumers translate higher home prices into spending and that has been lower lately because of the higher mortgage rates.
Running Out of Cushion
Greenspan
is also conveying an impression recently that the need to act
is becoming more critical. He also seems to be losing a little
patience. The economy has been absorbing this excess demand in
two waysthrough falling unemployment as more eligible workers
have been coming into the workforce and sharply rising imports.
but there are limits to both.
Tightening Labor:
The unemployment rate is already at the lowest level in more
than a generation and wage increases will soon have to accelerate
if demand does not slow. In fact, overall wage costs are starting
to increase, and, in our opinion, have been significantly understated
because of stock options and other incentives not accurately
reflected in government figures. The pool of potential workers
is falling and there is a limit to new hiring. Eventually, there
will be inflationary pressures, unless the Fed restricts business
from passing them along, or there will be a squeeze on margins.
Rising Trade
Deficit: As for international sourcing, some analysts
suggest that Greenspan is overly concerned about excessive demand
since the U.S. has the supply potential of the whole world to
meet it. But the bulging imports, up 12% in 1999 alone, are pushing
the trade deficit to record levels. It rose 65% in 1999 to a
record $271 billion. That means that foreigners are holding that
much more of dollar-denominated investments on top of those they
accumulated from the previous record U.S. trade deficits in 1998
and before.
This is the second
imbalance in the economy and one that is not without limits.
Foreigners will hold those dollars only as long as they have
confidence in the value of the dollar. Should they start liquidating
those investments or start spending them on U.S. goods in a much
bigger way, the U.S. money supply increases and adds to inflationary
pressures. The last time foreigners got tired of accumulating
dollar investments because of huge U.S. trade deficits, they
tried to turn them in for gold. It forced the U.S. to eliminate
the convertibility of dollars into gold, pushed gold from $35/ounce
to over $800 and ushered in double-digit inflation. The situation
is not necessarily comparable today, but it should remind us
that there are limits.
Credit Expansion
Consumer
Credit: In addition to imbalances in consumer spending
and the trade deficit, excessive money and credit expansion has
contributed to the Fed's problems. In 1998, when it was probably
about to start to cool the domestic economy, the Asian crisis
and fears of a global market meltdown, led the Fed to instead
pump substantial liquidity into the market and lower interest
rates. This easing contributed significantly to a continuation
of the bull market in 1999 and heating up in the technology sector.
Though it started to boost interest rates up modestly last June,
it again input significant liquidity into the market in the fourth
quarter in fear of potential severe Y2K disruptions. The result
was the huge fourth market rally and technology stock orgy.
At the same time, much
of the consumer spending splurge was financed with credit and
a substantial reduction in the consumer saving rate to all-time
record lows. In December, consumer debt totaled $1.4 trillion
and mortgage debt was $4.5 trillion, both up 10% from a year
earlier. Some argue that there is no serious imbalance involved
because the consumers also have huge capital gains. As usual,
however, the aggregates don't always tell the true story. There
is nothing to say that those consumers doing all the borrowing
are the same ones that have the capital gains. In fact, logic
would argue the opposite. A recent Fortune article reported
that sub-prime consumer debt has increased from $62 billion in
1993 to $400 billion in 1999. We seriously doubt that these sub-prime
borrowers are rolling in capital gains.
Margin Debt:
At the same time, we have also had a huge expansion in
margin account debt to finance stock trading. Margin debt rose
between two- and three-fold since March 1997. It rose 36% just
since last September, financing much of the fourth quarter surge
in technology stocks speculation.
Margin debt among NYSE
member firms was up another 7% in January alone, while stock
prices were generally falling. There is also considerable anecdotal
evidence that most of the increase in debt has been by a relatively
small proportion of investors doing short-term trading of fast-moving
technology stocks, along with hedge fund partnerships that utilize
leverage in their trading activities. There is also evidence
that firms offering Internet day-trading services are using a
substantial proportion of the debt relative to other traditional
brokerage firms. Though margin debt is still a relatively small
1.57% of market value, the ratio is about equal to the previous
peak just before the October 1987 crash.
Fed Targeting the Stock Market?
Putting
aside for a moment his comments on the stock market, Greenspan's
recent testimony erased most remaining doubts regarding the future
direction of interest rate policy. He stated that there is little
evidence that the American economyis slowing appreciably. He
repeated the fact that he is not looking at the CPI to determine
policy, that he does take the rise in oil prices seriously, and
that labor costs are potentially inflationary. He finally convinced
investors that the Fed would continue to raise interest rates
until domestic demand is slowed and brought back into balance
with supply. Stock prices have been weak ever since.
Perhaps more importantly,
as far as the stock market is concerned, many investors perceived
his comments as a direct frontal attack on the stock market.
For the first time, as discussed above, Greenspan introduced
what amounted to a speed limit for the stock market, arguing
that to control inflation, the prices of stocks and other assets
should rise no faster than household income. In fact, he even
stated that the only way to resolve the imbalance is to sharply
curtail the rise in stock prices. In 1999, household assets increased
twice as fast as household income. Some strategists went even
further in writing that Greenspan was more specifically saying
that he will continue to raise rates until the stock market
comes down.
Time to Take Out the Rifle?
The
one problem with the Fed's policy, especially as related to the
stock market, is that it's working too well for most stocks and
not at all for many others. After his last testimony, the DJIA
and blue chip stocks fell, but the technology stocks rallied
in a stick-it-in-your-face response. We've reminded our
subscribers on a number of occasions in recent months of the
historical negative relationship between rising interest rates
and stock market valuations. While it doesn't appear to be working
for technology stocks, it has for most others. In fact, it was
working all last year since more than half of all stocks declined
in 1999, with a substantial number falling more than 20% and
qualifying as a bear market. Some would also argue correctly
that a bear market for most stocks began in 1998. So far this
year, three-quarters of all the stocks in the S&P 500 are
down.
Beating Dead
Horses: Most of these stocks don't need any valuation
compression. There are already many very high quality stocks
whose earnings are growing nicely that are at record low valuations.
The rising interest rates have been pushing them even lower,
raising the cost of capital for the companies and disrupting
stock incentive programs. In the meantime, the speculative excesses
have continued in the technology sector, especially among highly
margined individual investors. This is the high-profile market
that Greenspan should really want to cool off. It is not just
that they are outperforming non-tech stocks. The massive transfer
of funds from value and other non-tech mutual funds to aggressive
technology funds or to individual stock trading further depresses
the rest of the market as funds must liquidate non-tech stocks
to meet their redemptions.
Focus on the
Sprinters: If Greenspan really wants to intervene in
the stock market, it may be time to put away the shotgun and
pick up the rifle. If Greenspan feels so strongly about the stock
market's impact on excessive consumer spending, why not focus
on the small number that are doing most of the aggressive short-term
trading? Why penalize all the other investors in the stocks where
there have not been very many capital gains over the past year
or so and why threaten the economic recovery?
Why not raise margin
requirements from the current 50% level? Greenspan has said it
is not an effective tool, but all we may need is a temporary
change in sentiment to break the speculative momentum. He has
said it is unfair to individual investors, but most of them are
not using margin to aggressively trade high-risk stocks. As for
the others, it may be fairer to slow them down before they lose
all their money. And don't forget the role in the speculative
binge played by leverage hedge funds. Would this be too much
intervention by the Fed in the market? One of the key roles of
the Fed is the growth and use of money and credit. As discussed
earlier, it has had no small role in creating much of the speculation
by injections of money and credit.
While a hike in margin
requirements would undoubtedly take some speculative steam out
of the technology stocks initially, it would not halt investment
in technology by mutual funds, pension funds and truly long-term
individual investors. Technology is a very attractive place for
long-term investment and breaking the speculative binge would
return them to more reasonable valuations for long-term investors.
Since so many stocks have already had their bear market, we also
don't believe, except for a short initial reaction, that an end
to the short-term momentum trading excesses would trigger a broader
market decline.
Editor's Note: With
over three decades of experience, Alexander Paris is one of the
best known and well respected economists and investment strategists
in the business. Throughout his career, he has expounded the
virtues of his unique free-market credit-cycle approach to economic
analysis which has enabled him to predict all of the major turns
in the economy over the past few decades. Along the way, Mr.
Paris has authored several books, including two editions of the
best-selling The Coming Credit Collapse, which accurately
forecast the past credit problems in the banking, consumer and
corporate sectors, and A Complete Guide to Trading Profits,
which explains technical analysis in the stock market.
With his economic philosophy
as a centerpiece, Mr. Paris founded Barrington Research Associates,
Inc. and Alexander Paris Asset Management, Inc. to advance a
top-down approach to identify those industries and individual
companies which would specifically benefit from economic and
market trends. Barrington Research Associates, Inc. is a brokerage
firm which provides economic and investment research to institutional
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Alexander Paris Asset Management, Inc. is a registered investment
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