In his classic investment book "Winning On Wall Street", Martin Zweig demonstrates the relationship between official US interest rates (the Discount Rate) and the performance of the US share market. He shows that, a large percentage of the time, a rise in the discount rate leads to lower average share prices and a drop in the discount rate leads to higher average share prices. One or two rate increases within a 6 month period are considered moderately bearish for the stock market whereas three or more rate rises within 6 months are considered extremely bearish. Many Wall Street analysts and financial commentators now believe that the Fed will increase interest rates during the next FOMC meeting at the end of June, but also believe that this increase is already factored into the market and is not a bearish development. In fact, many are putting a very positive spin on the potential rate rise in that it supposedly shows the Fed's vigilance in combating inflation, thereby prolonging the economic expansion. Wall Street is, therefore, preparing to fight the Fed.
Paradoxically, some of the most ardent bears are also preparing to fight the Fed in a way that does not directly relate to Zweig's "Fed Indicator". These bears believe we are headed inexorably towards a deflationary collapse precipitated by a major downturn in the stock market. The reason they are fighting the Fed, without realising it, is contained within Alan Greenspan's testimony on 17th June. Following are some extracts from this testimony with my comments shown in brackets.
"But bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. (Bubbles are never apparent to those who are wrapped up in the bubble, otherwise the bubble could not exist in the first place. However, those who are not consumed by the bubble are able to identify its existence using a combination of fundamental and psychological factors) Betting against markets is usually precarious at best." (Betting against an established trend is precarious for investors and speculators, as gold market bulls and stock market bears have discovered during the past several years. The last time I looked, though, the Fed's charter was not to bet either for or against markets).
"While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy. The bursting of the Japanese bubble a decade ago did not lead immediately to sharp contractions in output or a significant rise in unemployment. Arguably, it was the subsequent failure to address the damage to the financial system in a timely manner that caused Japan's current economic problems. Likewise, while the stock market crash of 1929 was destabilizing, most analysts attribute the Great Depression to ensuing failures of policy. And certainly the crash of October 1987 left little lasting imprint on the American economy." (This is the key point – Greenspan believes that the Fed will be able to act quickly and decisively enough to overcome the effects of a bursting bubble. His belief is based, in part, on the success of the US monetary authorities following the 1987 stock market crash. This belief must have also been reinforced by the results of the Fed's actions during the 4th quarter of 1998. In both cases, a massive injection of money was able to calm the financial markets.)
"Someday, of course, the expansion will end; human nature has exhibited a tendency to excess through the generations with the inevitable economic hangover. There is nothing in our economic data series to suggest that this propensity has changed. It is the job of economic policymakers to mitigate the fallout when it occurs, and, hopefully, ease the transition to the next expansion." (In other words, it is the job of economic policy makers to provide the markets with whatever amount of money is necessary to rejuvenate the expansion).
I had previously thought that the Fed would not raise rates for fear of bursting the asset bubble, thereby causing a recession. However, it now seems almost certain that official rates will be raised at the end of June. It also appears, based on Greenspan's recent testimony, that the Fed chief thinks that policies can be put in place to circumvent the debilitating effects of a bursting bubble. Reading between the lines the Fed is telling us that, if things do go off the rails, the monetary spigots will be cranked open to whatever degree is needed to restore liquidity to the markets. And what is the extent of their power to make good on such an assurance? Well, when it comes to the creation of new money their power is only limited by the amount of Dollar depreciation that is politically acceptable.
The willingness of both the bulls and the bears to fight the Fed may result in both groups being proved wrong. The bulls will be proved wrong because, even if the market does power to new highs immediately following an increase in rates on 29th June, a severe correction is likely to follow during the August-October time period for two reasons. Firstly, a surge in the stock market following the first rate increase will sow the seeds of a second rate increase. Secondly, the market is likely to fall due to the weight of its own extreme valuation levels. The bears will be proved wrong because, if the market does fall substantially, they will fail to recognise another terrific buying opportunity.
Those who are
a) preparing for deflation, or
b) anticipating, in the near term, the start of another major leg upwards in the great equity bull market, should remember: "Don't Fight the Fed"Milhouse
Hong Kong
23 June 1999The reader is invited to respond to Milhouse's wisdom via email: sas888@netvigator.com
Also by Milhouse
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