ED CHAIRMAN ALAN GREENSPAN UTTERED the quote above in his semi-annual testimony before Congress. He was making a point about consumer behavior in the present economy. Ironically, the quote is best taken in reference to the Fed itself.

As we find ourselves in a slowing economy, teetering on the edge of recession, the Fed is often portrayed as the hero riding to our rescue. Ironically, they're the source of the problem.

Less than two years ago, the economy was booming, consumer confidence was high, and, earnings were rising. The Fed governors whipped themselves into a paranoid frenzy, raising interest rates to fight non-existent inflation.

As the bizarre tightening continued, we became more an more concerned because

…bull markets and economic expansions don't end because they run out of steam, or even because of increasing inflation. No, they traditionally end because the Fed overreacts. Usually when they start tightening credit, they go too far and send the economy into recession. They've probably done it again. (see July 2000 True Facts

How Did This Come About?

Contrary to their denials, the Fed seemed inordinately preoccupied with the stock market. This was evidenced as early as 1996, when Fed Chairman Greenspan cited investors' "irrational exuberance. Presumably, the soaring stock market fed consumer confidence, which in turn traditionally fueled inflation.

There's no question the market was frothy. Investors were tripping over each other to buy the latest dot.com while established companies traded at triple digit P/Es. No one would deny (at least in hindsight) that this was a market bubble.

So the intrepid Fed set out to save us before our irrationality set off another wave of inflation. As we feared though, they overreacted.

Bubbles in the Bathtub

The Fed's tool is monetary policy. Their preferred means of implementation is manipulation of interest rates. Once they began to fear potential inflation -- even though there were no indications it actually existed -- their remedy was higher interest rates and lower liquidity.

To see what went wrong, let's stick with the bubble metaphor. Think about bubbles in a bubble bath. As time goes by, more and more pop and eventually, they're all gone. If you want to make some more bubbles, just pour some soap in the water, turn on the spigot for a few minutes, and you're back in business.

Market Gauge

Source: Baseline The Inventory/Sales Ratio rises when either inventories increase or sales fall. In either case, profits fall and so do stocks. In the second half of 2000, the Inventory/Sales Ratio started rising, and the decline in the S&P 500 accelerated.

The Fed didn't want to wait for the market's bubble to run its course. They wanted to speed the process. Monetary policy slows the market (and the economy) by draining liquidity though higher rates.

If you think back to the bubble bath, you can certainly get rid of the bubbles if you drain all the water out of the tub. However, without the water (liquidity), it takes longer to make new bubbles (move the economy forward) since now you have to refill the tub (add liquidity). For all intent and purposes, we're now sitting in a dry tub.

Stagflation?

Fortunately there's nothing to hold them back from cutting rates as much as they see fit. Contrary to January's aberrant PPI and CPI reports, inflation is no immediate problem. Just as December's drops were overstated, January's inflation increases were overstated, too. Unseasonably cold and warm temperatures have strange effects on consumer spending patterns.

The prospect of rising prices flies in the face of the real cause of the current economic slowdown. As the nearby chart illustrates, the present condition is the result of inventory build-ups. As the inventory/sales ratio has increased, the S&P and the economy have fallen off. According to the chart shows this is usually the case in a recession.

But think about it: If you're a manufacturer with increasing inventories and falling sales, are you going to raise prices? Of course not! To move your inventory you'll cut prices. That certainly isn't the recipe for another bout of inflation.

Even the bond market, ever vigilant for bad news, isn't afraid of inflation. While yield spreads between Treasury securities and corporates have remained stubbornly wide, this is more a function of corporate credit concerns than inflation fears. As of late February, the bond market was pricing in another ½% Fed cut in the near term with additional cuts also a possibility.

What Won't Work

Interest sensitive stocks such as financials and consumer cyclicals typically lead the charge, followed by cap goods and technology stocks. Yet these are the very sectors that are currently taking a pounding. What's up with that?

One theory has it that everyone knows the trends so no one's buying, waiting instead for the blast-off. Another school of thought is that the economic slowdown will be deeper and more protracted than anticipated. As a result, it will take significantly lower rates and a longer recovery period before any sector sees the benefits of easier credit.

Our sense is that even though the Fed broke it, this time the Fed alone can't fix the economy. While the economy may not fall into an official recession (two quarters of declines), we're certainly experiencing a profit recession. Stocks priced for perfection -- high P/E growth companies -- can't possibly meet, much less exceed, their earnings expectations.

Every time the market starts to gain a footing, a new batch of former high-flyers blows up with an earnings disappointment or warning. Each time this happens, investor's confidence is shaken a little more.

With the prospect of shrinking earnings, prices have to fall to bring P/Es back in line. This trend won't reverse itself until earnings again begin to rise. Lower interest rates won't have any immediate effect on corporate profits. The same 6-12 month lag that applied to higher interest rates also applies to rate cuts. While the Fed's belated corrective action will be beneficial in a half a year or so, it won't have a lasting impact in the near term.

Tax cuts won't do it, either. While President Bush's heart is in the right place, tax cuts -- especially if they aren't retroactive to the start of this year -- won't do much to spur the economy. (Of course it is wonderful to wrest our hard-earned dollars back out of the hands of wasteful politicians, but that's an entirely different issue.) Tax cuts only help when the savings are back in the hands of the spending and investing consumer.

What It'll Take

And that's what it will take to fix the Fed's mess -- a confident consumer. The nearby chart shows the strong correlation (+.84) between consumer confidence and the S&P 500. So as long as all the economic news is bad news and everyone fears more is yet to come, neither the economy nor the stock market will find a bottom.

Confidence and the Market

Source: Baseline Consumer confidence is highly correlated with stock market behavior. As more individual investors have entered the market, this relation has grown stronger over the past 10 years.

It's often pointed out that the market turns before the economy because investors are willing to look past near term weakness and invest for the future. This is true, but only when investors are confident they can see the light at the end of the tunnel.

Investors and consumers have grown jaded by the steady drumbeat of gloomy earnings and economic reports. The Fed and congress are too slow to have an immediate effect, so when will things turn around?

Here's our take: First, the stock market will turn before the economy. In the past, the market has started its ascent 3-6 months before the economy reverses course. There's no reason to believe it will be different this time.

Secondly, the market usually bottoms before earnings actually do. Here again is the phenomenon of investors looking past near term weakness when they perceive brighter prospects on the horizon. Again, there's no reason to believe this is different this time, either.

Third, markets turn when there's the proverbial "blood in the streets" with pessimism so rampant, even the final bulls have capitulated. We may not be there yet, but we shouldn't be too far away. Most of the excesses have been wrung from the market, and even bullish market strategists are apologizing for their earlier excessive optimism. Cisco's priced like it will never make another sale, Wal-Mart's below the low, everyday price, and WorldCom can be purchased for just a little over that 10¢ they charge for a one-minute long-distance phone call.

Finally, a market turn requires a catalyst. Instead of a rate or tax cut, the turning point usually is the result of an exogenous event. Perhaps a large hedge fund will initiate a buy program or maybe a merger involving a major corporation will be announced. These occurrences are not all that significant in relation to the stock market or the economy, but it's the perception of the events that provides the jump-start.

Isn't it ironic that such an irrational reaction to rather insignificant events can be the catalyst to accomplish what the Fed and Congress can't? Isn't it equally ironic that investors and consumers -- the very folks the Fed targeted in their ill-advised tightening campaign -- are the only ones who can fix the current problem?

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