January 2001
Dear Al
| "We met the enemy and he is us." |
| -- Pogo |
ORRY ABOUT NOT WRITING FOR AWHILE, but you know how it is. After surviving Y2K, we were irrationally caught up in the equity market's exuberance. We spent the first couple of months chasing hot Internet IPOs and paying 120X earnings for any and every tech stock.
In hindsight, we should have acted more prudently, like you and your Fed governor friends. Like you guys, we should have seen specters of inflation hiding under every couch and behind every tree. We should have realized that an expanding economy and low unemployment can't coexist, and if they do, they have to be stopped.
Can't Stand Prosperity
And boy, you guys sure did a good job of that. After raising interest rates 1-3/4% in less than twelve months, you certainly drained the excesses -- the positive ones anyway -- out of the market.Not only did you send dot.coms into dot.comas, you cut the legs out from under all growth stocks. Breathing life back into low or no-growth value stocks was quite a feat indeed.
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 Source: Baseline The OPEC induced spike in crude oil is now reversing itself. Additional production coupled with falling demand has pulled prices back into the mid-$20s, and both the 200 and 50-day moving averages are rolling over. This, unlike the mid-$30s is a sustainable range. |
So anyway, we were pretty preoccupied in 2000 and hope you'll forgive us for not keeping in touch. Please don't hold our negligence against us, because quite frankly, nary a day went by that we didn't think of you and your Fed cohorts.
In fact, we started worrying back in the late spring (see Be Careful What You Wish For) that maybe you'd gone too far. After all, there is a delay between the time you raise interest rates and the effects are fully felt in the economy.
By late summer, with the economy slowing and corporate earnings falling, you guys were still talking trash about "inflationary pressures" and all that scary stuff. Even as late as your December meeting you were still fretting about the Ghosts of Inflation Future.
Crude But True
Now oil did more than double in price, and that was certainly the catalyst for our last inflationary bout, but the fact is, aside from all the yuppies tooling around in their giant 4-wheel drive land yachts, we just aren't as dependent on oil as we were back in the '70s. The U.S. is more of a service economy rather than the production economy of 30 years ago.Sure higher oil prices would affect us all, but to truly hurt, they'd have to stay sky-high for an extended period of time. Odds are, that just won't happen. Indeed, prices have already retreated to more reasonable levels.
Besides, oil's rise was the result of the OPEC cartel's concerted efforts to drive up prices by limiting supply. No number of Fed rate increases (or decreases for that matter) could change that.
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 Source: Baseline Throughout 2000, as the Fed tightened and the economy slowed, the spread grew between 10-year Treasuries and long-term corporate bonds. This chart uses the Treasuries (T10) as the base, showing a widening difference with corporates (BONDC). |
Signs of the Times
Of course as you obviously know, Al, a tight money policy in the face of a slowing economy can lead to recession. Have you guys thought about that lately?We certainly seem headed in that direction. Just consider:
- Corporate profits are stalling. By mid-December, more companies had pre-announced earnings disappointments than reported for the entire fourth quarter of each of the past three years.
- Unemployment, while still low, is back on the rise again. This reverses the trend that held since the mid-'90s.
- Consumer confidence -- what you Fed guys feared for so long -- has fallen to its lowest level since 1998 when everyone was afraid the Asian crisis would lead to a worldwide meltdown.
Do you think things are that bad now, Al? Maybe they are and maybe you do. Perhaps that's why you Fedsters gave us that surprise ½% cut on January 3. But you know, it's going to take some time to reverse your excesses of the past.
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 Source: Baseline After peaking in March, the dot.com implosion and continued Fed tightening sent the Nasdaq to its worst performance ever. The Fed didn't stop at taking the wind out of Nasdaq's sails, it sunk the whole boat. |
Your buddies over in the bond pits think so. In fact, they're so sure you've won the inflation battle, they've already factored in at least another ½% rate cut.
Then again, corporate bond traders aren't thinking so highly of you. Corporate bonds haven't rallied like Treasuries since you've choked off the money supply. Everyone's (justifiably) worried that businesses will have a harder time servicing their debt. With earnings falling and money tight, corporate buyers are demanding an increased risk premium.
Taking Stock -- Literally
Stock investors haven't been so reasonable. You Fed guys certainly showed them. You sent them from irrational exuberance to irrational pessimism. They've oversold last year's darlings and over bought the prior year's dogs.What once were risky growth stocks are now undervalued. On the other hand, supposedly safer value stocks are now overpriced, especially whey you consider their low growth rates.
Most importantly, you really showed those young 
whippersnappers who thought things were different this time and that they were on the cutting edge of the "new economy". Those Nasdaq jockeys went from the phenomenal returns of the previous three years to the worst performance in the index's history. In fact, Nasdaq's 40% hit was the worst return of any major index since 1937. That'll show 'em!
Some Friendly Advice
So, Al, now that you've shown them all who's boss, what do you have in store for 2001?Are you still worried about non-existent inflationary threats? Are you still concerned about the "wealth effect"? What if it works in reverse given investors dwindling wealth? Do you think you might see fit to continue cutting rates before it's too late?
Obviously you're much more on top of this than mere mortals such as us, but for what it's worth, here's what we'd suggest:
- Declare victory in the war on inflation. Take the credit, you deserve it.
- Cut the Fed Funds rate by at least an additional ¼% as soon as possible. We may be able to avoid a recession without it, but do you really want to take that chance?
We hope that by the time you read this you will have already cut rates again. We are, after all, equity investors.
If you take a more reasonable approach, the stock market may be able to follow up that dreadful 2000 with a happier 2001. That's usually the result of an accommodative Fed and a reasonably valued market.
So what do you say, Al, is it worth a shot? The way we see it, you and your Fed pals brought us to where we are now. You successfully fought off nonexistent inflation, now it's up to you to help us avoid a real live recession. Up until now, you've been your own worst enemy.
Anyway, that's about it from here, Al. Take care and stay in touch -- at least with the economy
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