Australia: America is still living in a boom-time fantasy

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America is still living in a boom-time fantasy BOND STREET It's four years since Dr Greenspan warned of 'irrational exuberance'. Has anything changed? Malcolm Maiden writes.

Wall Street traders desperately want Alan Greenspan to give them a reason to start buying shares again and the US Federal Reserve boss will oblige on Tuesday night Australian time by outlining another big cut in interest rates.

US traders will seize the rate cut like a drowning man grabs a life preserver but there is no guarantee that the third rate cut this year from the Fed will do more than shore up prices for a few days.

The problem is that, despite all the hand-wringing, US share prices are still high: declining earnings are leading the market lower and, while rate cuts eventually boost economic activity, Wall Street analysts say there is no "visibility" on earnings yet. That's a euphemism for their inability to predict when the downturn in earnings will bottom out.

As long as there is uncertainty about when earnings will rebound, Wall Street and the markets that are beholden to it, including Australia's, are vulnerable.

Although it lost 7.7 per cent last week and fell below the psychologically important 10,000 point support level on Friday, the Dow Jones Industrial Average of 30 blue chip stocks is still at the levels it briefly tested in March last year (when the tech-Internet boom ended) and at the point it confidently passed in April 1999 on its way to a record high of 11,722.98 points in January last year.

The 500 stocks in the S&P 500 index are back to levels last seen at the beginning of 1999, as is London's market. And, despite being absolutely pounded, the technology-stock laden NASDAQ market has only found its way back to the end of 1998.

One problem the tech stocks have is that, although NASDAQ has fallen by almost two thirds from its high in March last year of 5048.6 points (and by more than 20 per cent this year), it is still valued at over 150 times the annual earnings of the companies that comprise it.

The price to earnings ratio has been fairly stable recently, which means that the index's slide has only recognised earnings downgrades, not the new consensus that companies were being valued too highly during the market boom - and still are.

The US market's ability to take the rate cut and run with it is also, paradoxically, limited by its desperate desire to do so: the rate cut is the only positive news that is looming and traders have built a cut of at least a half a percentage point into prices.

As shares continued to slide late last week the expectation grew that the Fed would in fact be forced to bag the long iron and pull out the driver, in the form of a cut of three quarters of a percentage point. What that means is that Greenspan could conceivably trigger a sell-off if the rate cut is only a half a percentage point.

His problem is that the US economy is not faring as badly as Wall Street's histrionics suggest. Sure, the economy suddenly weakened in the new year. The downturn has also introduced Wall Street to the first full-blown stocks overhang in the information technology sector, which had previously been growing so strongly that it simply surfed through the economic cycle.

But recent retail statistics and job figures were stronger than expected and Wall Street is falling harder and further than the American economy it is meant to be a proxy for, and because it is still backing out of boom time valuations that reflected what the Fed chairman memorably called "irrational exuberance".

Alan Greenspan first used that term in early December 1996, when the Dow Jones average was trading at about 6,420 points - 3,400 points or 35 per cent below where it is today. The NASDAQ Composite index was at 1,300 points when Greenspan issued his warning, 31 per cent below last Friday's close for that market.

There has been much talk in the US about the "wealth effect" the '90s boom created, as soaring stock prices fed into consumption, and the risk that a reverse wealth effect is now contaminating the economy.

Consumer spending closely tracked the rises and falls in the market during the '90s and the wealth effect is estimated to have added two percentage points of growth a year to consumption. The theory that spending will contract sharply as the market goes down provides a real economy "hook" for a big rate cut in the minds of many commentators.

For example, Macquarie Bank's economist in New York, Rory Robertson, estimates that US equity-market wealth (measured by the broadest market index of all, the Wilshire 5000) has fallen by 9 per cent in the past six trading sessions and by about 17 per cent since the Fed last met to consider rates, and says the downturn is severe enough to prompt the Fed to act decisively.

But once again, while paper profits have been trimmed by the share price slide, the wealth that the boom produced is still largely intact. The Fed's own figures show that stockmarket losses wiped out strong gains in house values last year to trim net household wealth (assets minus liabilities) by $US842 billion ($1,684 billion) or 2 per cent last calendar year.

It was the first decline since the Fed began tracking household net wealth in 1952 and there will be more losses caused by this year's market slide. But as the US magazine Business Week observes this week, US household wealth boomed upwards by a staggering 71 per cent or $US17.6 trillion between 1995 and 1999. That's quite a cushion.

Wall Street shrugged off Greenspan's "irrational exuberance" warning in 1996 and, as the technology stock boom continued, the Fed chairman shifted position subtly, saying that productivity gains flowing into corporate profits from the introduction of new technology, notably information technology, could justify higher valuations for shares than had been applied in the past.

Whether there is a cause and effect between higher productivity and the share market is debatable. Yale professor and market bear Robert Shiller has demonstrated that there is no historical alignment between changes in corporate profitability and the level of the sharemarket.

He asks why, if the market has not tracked productivity and profits before, it would suddenly do so now.

But even if the relationship exists, it remains to be seen whether the Federal Reserve chairman believes they totally explain the gains the market can still claim against December 1996, when he issued his market-blipping "irrational exuberance" warning.

http://smh.com.au/news/0103/19/business/business5.html



-- Carl Jenkins (somewherepress@aol.com), March 19, 2001


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