| "Reason can never show us the connexion of one object with another, tho' aided by experience, and the observation of their conjunction in all past instances." |
| -- David Hume |
HEN MY SON WAS A PRE-SCHOOLER
and accompanied me to the grocery store or mall, I'd always snap my fingers at
the automatic doors. Magically (to him at least) the doors would always open,
allowing us to enter. He was convinced I possessed some sort of mystical power.
Now that he's older, he has a more realistic understanding of cause and effect.
Apparently Alan Greenspan's dad also fooled with his concept of causality, but unfortunately (for us at least), Mr. Greenspan never got past it. Compounding the problem is the fact that he doesn't apply his misconceptions to something as innocuous as supermarket doors; he deals with the financial markets.
As a case in point, consider Mr. Greenspan's recent attacks on the equity market. In several well-publicized speeches, he and a few other Fed governors have questioned the market's valuation, implying investor's overconfidence may lead to market instability. In addition, ever since his famous "irrational exuberance" declaration, the Fed appears to believe that a soaring stock market must lead to an overheated economy and naturally, inflation.
Attempts to "talk down" the market are efforts to stop this process before it gets started. Underlying this whole thing is the belief that a rising stock market causes inflation.
Predictions vs. Causes
But there is no causal relationship between the stock market and inflation. As you've probably heard before -- here in fact -- the stock market is a discounting mechanism. It puts a price today on earnings to be received tomorrow. Stocks with greater earnings command higher prices than those that don't.In essence, the market predicts future earnings. Not only does it reward individual stocks, a rising market can be a prediction of increased aggregate corporate earnings. When the market goes up, it's simply a prediction of rising corporate earnings.
Predictions aren't causes. You might conclude from clouds gathering on the
horizon that a storm is approaching. More often than not, your prediction comes
true and it does rain, 
but your
prediction doesn't cause the rain.
In a similar manner, a rising stock market may predict increasing corporate earnings. Surging earnings might (arguably) lead to an overheated economy resulting in inflation, but the market's prediction doesn't cause inflation anymore than your reading of the clouds caused it to rain.
Fed Effects
The Fed doesn't seem to get this distinction. While their attacks on the equity markets are misguided in regard to inflation, they are having effects on the markets themselves.
First and foremost, they've scared the bejeebers out of the bond market. In the past year interest rates have risen over a point all across the yield curve. Three quarters of this rise occurred since this summer when Mr. Greenspan and the boys started fretting about inflation and the stock market.
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At the first threat of impending rate increases, bond traders (a paranoid and nervous lot by nature) immediately started bidding rates up, staying well ahead of this summer's two meager .25% increases. When the long bond neared 6.5%, the bond guys were probably .50% ahead of the Fed.
The Fed didn't ease the anxiety when they took no action at their early October meeting. In fact, that was probably the worst of all possible alternatives. Had they tightened another .25%, investors would have concluded that having retaken last year's three rate cuts, the Fed was done. Had that happened, both the bond and stock markets would have rallied. Had they taken no action and not changed their goofy bias-thing, there would have been a smaller relief rally.
But no, they didn't take either of those alternatives. Instead, the Fed took no action yet announced a "tightening bias". Now this bias thing is a weird bird. It's supposed to indicate how they're leaning. Oddly enough, prior to both of the summer's increases, the bias was neutral. Makes you wonder: if they raise rates when the bias is neutral, what do they do when they're leaning that way to begin with, close the banks?
Perhaps we'll find out at the next Fed meetings. Then again, perhaps not. The Fed uses this sort of screwy mumbo-jumbo to keep the financial markets off guard. By publicly talking about "overvalued" equity markets and "biases", Mr. Greenspan's Fed has been able to inject enough uncertainty into the markets to keep them from steaming along and prevent them from "causing" inflation.
When all's said and done, the Fed has relied on these jawboning and obfuscation (don't you love that word?) tactics to a much greater extent than their actual rate moves. This appears to be a causal relationship Mr. Greenspan understands. It also explains why his personal investments are primarily held in Treasury Bills.
Excuses or Effects?
Fed-speak aside, the effects of the summer's rate increases are starting to be felt in the economy. There's usually a delay of 6-9 months between a Fed rate change and its impact on the economy, so this is right on schedule.
Aside from an occasional aberrant report, inflation still seems to be well contained. GDP is expanding, but at a moderate pace. The employment situation remains tight, but it continues to be offset by increasing productivity.
With inflation hovering around 2% and the real rate of interest at 3.5%, the long bond should be closer to 5.5% rather than 6.5%. Perhaps the bond guys took notice of this in early November, bidding the long-bond back down below 6.10%. This put it back in the 5.80% - 6.10% range from the first half of the year, and probably where it belongs now.
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On the negative side, higher rates (whether justified or not) are starting to have an impact on corporate earnings. Despite the fact that 3rd quarter earnings came in stronger than anticipated, more and more companies are warning that the 4th quarter's may actually be lower than predicted. While some of this may be due to Y2K concerns, odds are the real cause is a slowing economy.
To be sure, Y2K has already impacted some sectors and will undoubtedly affect others. Enterprise software companies have experienced a sharp drop-off in sales as IT managers focused on preparedness rather than upgrades. Banks and brokerages may suffer as cautious investors go to cash.
But for the most part, Y2K has been an excuse rather than a cause. Earlier this year, Compaq blamed Y2K concerns for a falloff in demand and an earnings shortfall. Several weeks later Dell reported record earnings on robust demand. Perhaps Compaq's customers are more Y2K sensitive than Dell's, but then what could cause that effect?
If A Then B
Rising interest rates and a slowing economy usually spell doom for bull markets. Higher rates raise the cost of borrowing and squeeze margins. A slowing economy lowers retail and corporate spending, further reducing earnings. Based on this, you'd think the Fed may have killed the bull.|
Monthly Starts and Ends to 10% Corrections Measured from 1946  |
Fortunately, this probably isn't the case unless the Fed continues to overreact by raising rates by more than another .25%. Since it's already factored into the markets, the actual increase will be anticlimactic, leading to both a stock and bond rally. Signs of this were seen in late October and early November when the market rallied in anticipation of the Fed's final action.
If the Fed would then step back, the markets could again trade on fundamentals. Quality financial stocks could return to historical valuations. Growth stocks would be freed from cloud of additional rate increases and could trade on growth rates rather than interest rates. Recovering foreign economies would be viewed on their sales potential instead of as inflationary threats.
Contrary to the Fed's misplaced fears, the stock market is really not overvalued. Following the 3rd quarter's correction, fully 56% of the stocks in the S&P 500 are down for the year, with a median loss of 2.8%. The forward P/E for the index is 22, still in the north end of the historical range.
 For most of 1999, the S&P 500 has closely traced its path from 1998. The fourth quarter provided most of last year's gain. Perhaps this year will follow suit as late October appears to have provided a breakout above the short-term downtrend. |
The market's resiliency -- even in the face of the Fed's silliness -- is quite remarkable. The secret is price stability. As we pointed out in July's True Facts, equity markets don't perform well in inflationary or deflationary environments. Instead, the best results are obtained in periods of stable prices. This is precisely what we've had, despite the fact that the economy continues to expand.
Unfortunately the Fed misunderstands this one, too. Again they postulate a causal relationship which simply doesn't exist. In the words of Fed Governor Laurence Meyer, there is an "inescapable trade-off" between growth and inflation.
The Fed may believe this, but there just isn't any evidence to support it. Growth, in an of itself, does not cause inflation. It can if growth results from rising demand and prices. But the expansion of the 90's has come from advances in technology and improving productivity. This has resulted in an expanding economy, falling prices, and a rising stock market.
As long as the Fed doesn't overreact, this can persist well into 2000.
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