Prudent Bear Market Commentary

The New Era and The Bank of England

January 24, 2000

Stock market action has been particularly choppy and disjointed, not atypical for option expiration week. Unfortunately, and we hope only temporarily, we have returned to last year’s phenomenon where the “blue chips” are generally under performing the speculative and more suspect stocks and industry groups. So far this week, the Dow has declined about 2%, although the S&P500 is basically flat. The Transports, dropping 2%, have suffered with the surge in oil prices. The Morgan Stanley Cyclical index has under performed, also declining 2%. The Morgan Stanley Consumer index and Utilities are flat. The financial stocks, having come to life at the end of last week, are falling back to reality this week, as the S&P Bank and Bloomberg Wall Street indices have dropped 3%. Elsewhere, the speculative juices are again running strong. For the week, the NASDAQ100 has gained 2%, and has now surged 10% since the lows of last Wednesday. The Morgan Stanley High Tech index has gained 1%, while the Semiconductors are unchanged. The Internet stocks have come to life, with The Internet index rising 2%. The NASDAQ Telecommunications index has surged 4%, bringing to 11% its gain from last Wednesday’s lows. The AMEX Biotechnology index has gained 6% so far this week, increasing year-to-date gains to 16%. The small caps have been strong as well, with the Russell rising 3% during the past two sessions. Many stocks have made significant gains. We see that from the S&P600 Small Cap Index, more than 20% of the stocks have gained more than 10% month-to-date. For the NASDAQ Telecommunications index, almost 20% of the stocks have gained 25%, and 37% have gained 10%. Of the 100 NASDAQ100 stocks, 39 have gained 10% or more.

We have little doubt that the proliferation of derivative trading is a major factor fueling volatility, while also increasingly distorting the marketplace. Today, the CBOE reported total option open interest of 58.7 million contracts, an increase of 9.7 million from year-end. Call option open interest now exceeds 35 million contracts, having increased 20% so far this month.

Beginning next week, we will have commentaries on Tuesday, Wednesday and Friday. Today, from an “International Perspective,” Marshall Auerback discusses, “THE BANK OF ENGLAND DOESN'T BELIEVE IN THE 'NEW ERA'…YET”

Last week, the Bank of England announced the first of what markets expect will be a series of interest rate rises. The rise of 0.25 per cent to 5.75 per cent had been widely predicted, following recent rises in the bellwether signposts historically followed by the British central bank -- namely, rapid growth in house prices, mortgage lending, and rising wage increases.

Equally predictable was the criticism of the decision launched by trade unions and manufacturers based in the less affluent North. What was more striking, however, was the number of reputable economists and commentators who criticized the decision on the grounds that the Bank was, unlike its American counterparts at the Federal Reserve, paying little attention to the changing structure of the British economy and, in particular, the alleged role of the productivity miracles being wrought by the diffusion of high technology into the broader economy. Needless to say, such critics of the Bank cited the US experience as the proof in the pudding and argued that this should have had implications for the Bank's future conduct of monetary policy.

There's only one problem with this line of reasoning: it's wrong on all counts. For a start, despite the fact that Britain has one of the highest rates of personal computer diffusion in the world, with a large number of businesses making widespread use of the "Net", e-commerce, etc., the economy has not yet "followed the plot", so to speak. This widespread usage has not yet generated the higher productivity rates expected by the champions of the new economy. Indeed, for all of the United Kingdom's supply-side deregulation, and market-friendly government policies, the fact is that labor productivity rates still lag well behind that of supposedly sclerotic, dirigiste France and Germany.

And what of the claimants' model economy, the United States, where so much of the current mania in high tech stocks has been largely predicated on claims of a productivity miracle based on substantial advances in information technology? Federal Reserve Chairman Alan Greenspan has made countless speeches to this effect, thereby legitimizing talk of a "new paradigm". In a way that has found no echo in Britain, continental Europe, or any of the other major G-7 nations, Mr. Greenspan continues to harp on the new high tech based productivity revolution. This is a cudgel which has now been taken up by his fans in the United Kingdom (even in the supposedly financially literate British Financial Times), with which critics continue to batter the dinosaurs who are said to generally comprise the Bank of England's independent Monetary Policy Committee (MPC).

But a great deal of what Mr. Greenspan is claiming for the US economy is based on highly contentious and questionable economics, and Mr. Greenspan himself is surely aware of this, given that the Federal Reserve's own consultants have written papers questioning the existence of the late 1990's productivity miracle. One of those consultants, Professor Robert Gordon of Northwestern University, has done one of the most extensive studies on this phenomenon and argues that the entire increase in recorded productivity in the American economy over the last 5 years comes from one small sector, the manufacture of computers, which accounts for only 1.2% of GDP. He illustrates that non-durables show no improvement in productivity and durables ex computers actually show a decline. His study illustrates that there is no evidence of "benefits of computers and other electronic equipment spilling over to the sectors of the economy that have heavily invested in them."

Furthermore, the productivity miracles wrought in the manufacture of computers themselves only show up because of the introduction of a new measurement, not used in any other sector of the economy, which seeks to measure the change in the utility provided by computers -- the "hedonic deflator". Essentially, this is a gauge economists seek to use in order to quantify the functional capacity of the computer. Because computers produce a readily measurable output in units of computational power or memory capacity, it is a sector of the economy that readily lends itself to this kind of analysis. However, attempts to apply this deflator to other sectors of the economy undergoing similarly impressive rates of technological progress (e.g. cars or health care) have largely failed, and government statisticians have therefore avoided introducing such a measure into other economic sectors. If one were to eliminate the use of this deflator within the computer industry itself, we would see that the rise in output and productivity allegedly wrought by computers is largely of statistical origin, solely predicated on the use of the hedonic deflator.

We do not wish to engage in a highly technical discussion dealing with the validity of extending the use of this deflator to other sectors of the economy. Nor do we wish to get into a nitty-gritty analysis on the nature of the hedonic deflator itself as a useful measure of productivity. It is merely sufficient to note that the United States is the only major economy in the world to employ this device, however justifiable, and that any comparison of the relative rates of productivity between the USA and Great Britain must start with that fact. This elementary statement that one shouldn't compare apples with oranges is, of course, never highlighted by the champions of the "New Era", when they argue that the Bank of England should hold off on further rate increases. But the British "Greenspan groupies" who adhere to the Fed chairman's belief in the "new paradigm" are in fact hanging their arguments on a very thin reed which is a highly controversial area within the economics profession. The Fed Chairman is undoubtedly aware of this, as must several economists be in the United Kingdom. Yet no one has called the bluff of the New Era crowd by publicly pointing out this statistical mirage in US productivity. Of equal concern is evidence that this spurious productivity story is gaining adherents within the Bank of England's Monetary Policy Committee, notably amongst inflation "doves" such as Ms. DeAnne Julius.

It is bad enough when the head of the world's most important central bank takes liberties with statistics to build a case for the new era, thereby perpetuating serious financial imbalances within the US economic system. What is even worse is when this questionable behavior becomes the basis for some to criticize other central bankers who look askance at the Fed's conduct of American monetary policy. Britain has had nasty recent experiences with asset bubbles in the late 1980's and early 1990's and is acting now on the basis that the preservation and encouragement of such bubbles ultimately has dire economic consequences. It would be a shame if a capitulation to America's "new paradigm" promoters ultimately created the makings of a similar fiasco over here, particularly given the paucity of hard evidence to support such a massive shift in Britain’s currently successful conduct of monetary policy.

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