US bubble that's waiting to burst

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WE ALL know the history: this spring the Federal Reserve was considering raising interest rates to damp down US inflation. Then on 17 August Russia defaulted and the Fed reversed tack, in quick order cutting interest rates three times. One time, in fact, it appeared to cut rates explicitly for the benefit of the stock market. What we don't know is why Alan Greenspan cut interest rates to help Wall Street. What did he know? It must have been something extraordinary to justify a cut in interest rates, on a day on which the Fed's open market committee did not meet, but during stock market hours when shares were already rising. At the time, the finger of suspicion was pointed at an irrational increase in nervousness by lenders, with fears that this would lead to a credit crunch. But that is hard to believe. As Tim Congdon of Lombard Street Research points out, a 21 per cent a year rise in bank credit rates indicates a credit craze not a crunch.

It is no secret that the Fed has allowed an extraordinary bubble to develop on Wall Street. Looking at the disastrous state of the post-bubble economies of Japan and Asia, the Fed is clearly right to be nervous. It is reasonable to assume that the Fed was scared of news breaking that could cause the bubble to burst.

The most likely reason for the Fed to be scared of the stock market is the options market, which has taken over the role which "portfolio insurance" was meant to provide prior to Black Monday on 19 October, 1997. Portfolio insurance was thought to be mathematically sound, even though it appeared offensive to common sense, as it involved selling shares if the market fell and buying them if it rose. What went wrong in 1987 was that the market moved too sharply. The mathematicians had assumed that share prices moved by small steps. Black Monday proved the contrary.

Portfolio insurance is now purchased through the options market. The basic principles have not changed but the risk- takers have. The investors who lost out in 1987 were the owners of ordinary share portfolios, with capital equal to 100 per cent of their exposure. Those at risk today include dealers, whose capital is a fraction of their exposures.

Dealers like to assert that they have these risks under control and that their mathematical models allow for "discontinuity". However, price discontinuity depends on the size of the options market and this has grown hugely in recent years. The risk that option dealers could find themselves with uncovered positions after a sharp fall in the market has therefore risen dramatically.

Furthermore, the rescue of Long Term Capital Management, whose maths proved as faulty as portfolio insurance, has increased doubts about all such models.

Long Term Capital Management may have had much to do with the Fed's behaviour. When the news first hit the headlines, attention was on the "convergence trades" in bonds which had gone wrong. Since then it has emerged that the hedge fund was also a huge holder of equity positions. The Fed may well have been concerned that unwinding these after the market's sharp fall in the autumn could set off just the "price discontinuity", which might set off a downward spiral in share prices and possibly cause the bankruptcy of some major option dealers.

Whatever lay behind the Fed's behaviour it underlined the growing importance that central banks and finance ministries are placing on the fluctuations of share markets. In Japan the government has been seeking to prop up the stock market by the price-keeping operation. This has involved investing money from the post office and state pension scheme in the stock market. This year Hong Kong has joined in the act and now the Fed behaves in a manner which seems only rational if it were seeking to prop up the stock market. If the cut in interest rates had been needed for the economy, the slow way in which they operate means that the timing of the announcement could not possibly be justified.

The bond market has long been considered fair game for official intervention and it could reasonably be argued that the stock market has a greater impact on the economy, thus justifying this new trend. Its most obvious feature, however, is that this intervention is introduced only to support stock markets never, so far at least, to try and damp them down. If they had we would not be in such a mess.

It has long been argued by many economists that central banks should pay attention to asset prices, as well as to those of goods and services.When asset prices are allowed to get out of line with goods' prices and incomes, it becomes very difficult to get them back into line without disrupting the economy. This is because there are only two ways to get things back to normal; one is to have goods' prices and incomes rise through inflation and the other is to have asset prices fall. When asset prices have large falls, individuals respond by pushing up their savings. If the prices fall sharply the drop in consumption tends to be rapid and the economy can easily fall into a deflationary spiral. The likelihood of this happening in the US today is uncomfortably high. The savings rate of the household sector has actually become negative, compared with a long-term average of around 5 per cent or more of GDP. A sharp return to more normal conditions could therefore precipitate the US into a sharp recession. As the lack of savings is the mirror image of the asset bubble in share prices, there is a high probability that a stock market crash would set off a major recession.

The Fed is thus in a frightfully difficult position. Ideally, it would have stopped the bubble in its tracks by raising interest rates back in 1995, but unfortunately it didn't and the mistake can't be undone. The result was that the stock market, which was already over-priced in 1995, has moved to a level which poses a threat to the world's economy. Mr Greenspan has made it clear that he knows this and is well aware that he has a bubble on his hands.

The stock market's bubble has not only pushed personal savings down to an unstable level, it has pushed down the cost of capital. It is a standard principle of economics that the cost of capital should equal its return. If capital is too cheap, then savings fall and investment rises, setting off inflation. If capital is too expensive savings rise, investment falls and the economy is plunged into recession. This means that when returns on capital are high, P/E multiples should be low and vice versa. Virtually all stockbrokers, however, appear to believe in a world where this only applies when returns on capital are low. They are quite willing to believe that high P/Es are justified in Japan because profitability is so poor, without seeing that the same argument justifies low P/Es in America, when profitability is high.

If the combination of high P/Es and high returns on capital is left unchecked then the cost of capital will remain below its return and inflation will accelerate. But this high return on capital is notably absent in other parts of the world. In Japan and the rest of Asia, returns are exceptionally low. Capital thus tends to flow from Asia into the US, bringing down returns in there and raising them in Asia. If things work smoothly this should stop the US overheating and help Asia recover.

Unfortunately, things are unlikely to work smoothly, because the US stock market is so high. Either profitability and monetary growth will slow or inflation will pick up. Either event is likely to be accompanied by a stock market crash. The outcome seems assured; only the cause and the timing is in doubt. It is widely thought that stock markets don't like uncertainty. Today at least nothing could be further from the truth. It is only the uncertainty between rising inflation and falling profits that keeps the stock market from crashing. The Fed wants to preserve this uncertainty and this may simply make matters worse, as the higher the stock market goes the further it will fall and the deeper the recession will be. It could, however, be argued that the Fed should try to create a bit of inflation. This would reduce the risk that when the US goes into recession we have the whole world in the sort of deflationary spiral that Japan's experience has shown to be so difficult to cure.

In fact, it is unlikely that the Fed has any such intention and is just trying to postpone the evil day.

Andrew Smithers is the managing director of Smithers & Co