Feb 18, 2000|
Greenspan: To kill or not to kill?
Mr. Alan Greenspan, Chairman of the Federal Reserve, the powerful central bank of the world's most powerful economy is in an unenviable position of trying to calm what has clearly become a runaway economy. In late 1998, Mr Greenspan had to cut interest rates in the face of the collapse in Russia and the losses of LTCM, a hedge fund that made losing bets. Since then Mr. Greenspan has been trying to cool the stock market with interest rate hikes: gentle but persistent. So far his soft approach has been a failure and the NASDAQ, the barometer of frenzy in technology stocks closed at another record on February 17 on record volumes.
There are three major ingredients that cause share prices and stock markets to rise:
- past profits of the company,
- expectations for the future profits,
- alternative assets one can invest in for a risk-reward relationship
Traditionally, central banks are concerned about inflation and adjust interest rates to account for future, expected inflation. But now Mr. Greenspan may have to use interest rates to discipline financial markets that have flown because of easy money and low implied risk. By controlling the rates of interest (the cost of capital) in the US economy, the Fed is sending out a signal not only on its own macro concerns of inflation (a responsibility of every central bank) but also on the level of risk attached to any investment alternative.
If interest rates are 5% on risk-free government bonds, then any other asset must give a better return for the higher risk that it has relative to the government bond. As Mr. Greenspan increases interest rates in the US, he is not only fighting inflation (wage costs and oil prices that are on the rise) but is also setting a benchmark for the rate of return on all risky assets. But Wall Street does not seem to be bothered by Mr. Greenspan's desire for a soft landing - the ability of a central bank to gently convert a roaring economy into a tame and alive cat. Every marginal hike in interest rates is seen as a victory for the risk taker and a loss for the cautious (some would argue sensible) investor. To kill inflation in the early 1980's Paul Volcker, the then Chairman of the Federal Reserve saw interest rates rise to 21%. Mr. Greenspan, while speaking of irrational exuberance for four years, has done little to kill the rocketing valuations on Wall Street.
Despite all the positives of technology and the increasing use of the internet, there are limits to the relationship between a business and the valuation of the business. The traditional valuation measures of Price-to-Earnings and Price-to-Cash Flow have given way to more aggressive ratios such as Price to Sales. My guess is that many of these ratios have been created to justify high valuations rather than be the reason for those high valuations. When nothing ordinary fits, the extra-ordinary is called upon to rationalise and to justify. Many argue that valuations of technology businesses have been stretched beyond recognition. Mr. Greenspan is aware of this and even made a reference to one internet company raising capital that said it had no business and no business plan but intended to develop one.
And history is full of examples of business wonders that did not translate into real profits for everyone. As Warren Buffett pointed out in a recent article not many made money on previous technological revolutions that created hundreds of auto airline, and electricity companies. At the height of Japan's bubble, I have been told, the Emperor's Palace Grounds in Tokyo was worth more than all of Canada. We saw that in India with our own real estate bubble where at one point in time the value of property in Bombay must have been a significant portion of India's GDP. And we have had our share of finance and leasing companies that promised us upwardly, mobile returns.
Bubbles ultimately burst. Mr. Greenspan has the unenviable task of killing the frenzy in the technology sector in the US (that has now spilt over to all parts of the world) or going down in history as the central banker who was unable to stop a frenzied stock market from causing a major economic collapse.
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