The Greenspan Gambit
Adam Hamilton January 5, 2001 3668 Words
Noah Webster’s namesake dictionary defines “gambit” as an opening move in a chess game where a player seeks to obtain some advantage by sacrificing a pawn or some other piece.
Long a game of kings and generals, chess has taught crucial strategic thinking skills to countless generations of leaders. Created in India and imported to Persia around the sixth century, the game has an amazingly intricate and mesmerizing history. Interestingly, chess was even banned for short periods of time all over the world because the game was believed to be too powerful (very few leaders wanted strategic thinking peasants), too time consuming, or a cultural threat to indigenous contests of mental prowess and wit. Chess is truly fascinating and has virtually infinite strategic depth…
Fast forward to the dawn of a brave new millennium and enter Alan Greenspan, who may or may not be a chess player, but he is certainly a strategic thinker. Unless you are living amongst the headwaters of the Amazon in the deep dark bug-infested jungles of northwestern Brazil, chances are you are well aware of Alan Greenspan and the United States Federal Reserve’s emergency inter-meeting interest rate cut.
Near high noon of the second trading day of the new year, before traders had even managed to shake off their New Year’s Eve hangovers, the US Fed made an extraordinary intervention in the markets with all the finesse and subtlety of a fleet of B-52s carpet-bombing Iraqi Republican Guard units in sand-filled trenches in Kuwait.
Alan Greenspan and his merry band of marauders made an unprecedented massive rate cut between normal Federal Reserve Open Market Committee meetings. The FOMC last met on December 19, where it flipped from an inflationary tightening bias to a recessionary loosening bias faster than a quickdraw gunslinger on speed.
On January 3, 2001, the FOMC board voted 5-0 to slash the overnight bank lending rate, the fed funds rate, by 50 basis points to 6%, and to carve 25 basis points off the discount rate leaving it at 5.75%. (The joy was already spreading on January 4 when the FOMC crusaders hacked another 25 basis points off the discount rate, leaving it quivering in the corner at 5.5%.) The Greenspan Gambit was unleashed on an unsuspecting financial world…
The reaction in the US equity markets to this surprising and sudden move was phenomenal. Over Wall Street, ominous storm clouds cleared, a soft azure sky beckoned, and a golden glow filled the stock exchanges. Traders leapt for joy and openly wept, daisies bloomed and cute baby bunnies played on the trading floor, and everyone was convinced there would be peace in the Middle East if only Barak, Arafat, and a desperate Bill Clinton would make a sojourn to the NYSE floor to work out their small differences. From the looks of things, it was THE long-awaited Second Coming of the conspicuously missing-in-action equity bull.
After the initial shock of the Fed’s emergency operation, the warm afterglow faded to pure adrenaline and naked greed as speculators, remembering their wild ride of a mere 12 months ago, started screaming “Buy!” “BUY!”. The ensuing orgy was a sight to behold, and surely it rivaled any party the wild Romans could have thrown thousands of years ago. Records were shattered like delicate stained glass windows in a raging hurricane.
The highly speculative NASDAQ roared up to a dizzying gain with unprecedented fury. It was the BIGGEST point gain ever for the NASDAQ, 324. It was the BIGGEST percentage gain ever for the NASDAQ, 14.2%. It was the HEAVIEST volume day ever for the NASDAQ, 3.1b (that’s billion with a capital B) shares exchanged. Feeling kind of blue at being left out, the NYSE followed the stampeding NASDAQ’s example and had its own HEAVIEST volume day ever, almost 1.9b shares. (Incidentally, the NYSE record lasted only 24 hours as volume on that exchange exceeded 2b on January 4, the day after the launch of the Greenspan Gambit.)
The graphs below show January 3 intra-day charts for the big three US indices. We know this will be demanding, but we ask you, in the spirit of the strategic challenges offered by the game of chess, to TRY and determine what part of the day the Greenspan Gambit was heralded to the weak sputtering markets...
Compared to the NASDAQ and S&P 500 reaction to the explosive Greenspan Gambit, the DJIA was fairly sedate in terms of percentage gains. As the above charts make readily apparent, the nexus of the speculative mania is still focused like an industrial laser on the brave new-era NASDAQ universe. As such, we will take a look at the NASDAQ from a fundamental perspective. Was the mega-rally based on fundamentals? Will it stick? Has the bull begun to bellow and stampede again? Is Greenspan the bulls’ new champion?
As every seasoned investor knows, the ULTIMATE fundamental reality of the entire investment and speculation cosmos is cashflow. Over the long run, every investment regresses to a similar mean valuation surrounding the cash it is able to spin off. When investments are able to generate much more cash than many-century old average rates of return would suggest, their prices are bid up as the market corrects the undervaluation anomaly. When investments are too richly valued, spinning out meager amounts of cash for their stratospheric prices, they ALWAYS trend back down to an average rate of return over the medium term. NOTHING is more important for long-term strategic trading and speculating than underlying cashflows.
While cashflow is without a doubt the ultimate driver of valuation, the peculiar psychology of us emotional humans invariably causes short-term distortions. As has been irrefutably demonstrated throughout all of market history, there are periods of unusually high levels of greed that cause folks to prod stock prices to unsustainably high blue-sky levels that are completely divorced from reality. After these mania booms, there is invariably a bust. Greed turns to fear, as wise old market sages sell before the top and amateurs are financially pillaged as prices plunge into the post-boom bust. As the speculative bubble deflates, the most naive investors are left holding the soon to be empty bag. It is truly an ugly event to witness, but the ensuing bust after a boom is as inevitable and irrevocable as winter following summer. As long as the earth revolves around the sun and maintains its 23.5 degree axial tilt, the seasons will relentlessly progress. As long as human beings are emotional creatures, periods of utter terror will follow the stunning orgies of unrepentant greed.
A mere year ago, we were some of the unfaithful malcontents screaming “BUBBLE!”. The bulls kept telling us in the contrarian camp how utterly stupid we were and how “this time it IS different”. They claimed the New Era and Internet freed the financial world from the lessons of millennia of human speculative history. In an essay titled “To Crash or Not to Crash”, published last August, we attempted to make the case that the NASDAQ had CRASHED in March-April 2000, and that we were moving into a brutal bear market. Being contrarians, we are used to derision and ridicule, and our bullish acquaintances laughed at our obviously archaic folly.
Today, however, the general climate has changed dramatically and most bulls are willing to admit that there was indeed an “internet bubble” that burst last spring. Although we applaud them for their newfound sobriety and 20/20 hindsight, unfortunately for them they are still missing a few important points. The bubble was not just the Internet, it was the entire NASDAQ, and to a slightly lesser extent the US dollar, the S&P 500, and the Dow 30. Also, the lessons of financial history have never been proven wrong although they are mocked continuously by the permabulls.
If the NASDAQ is indeed a bubble whose bursting time has passed, maybe Greenspan thought the bust was finished and decided to hasten the end of the speculative excess he and his cronies created through sloppy and undisciplined credit growth. Was this the purpose of the Greenspan Gambit, to herald the end of the bust?
Historically, busts end with an unnatural aura of fear penetrating the whole market, with P/E ratios (earnings are an excellent long-term proxy for cashflow) trading at half normal levels, and with a scary capitulation selling panic.
Obvious to anyone watching bubblevision instead of soap operas and infomercials (er … wait a second, bubblevision IS a giant soap opera-infomercial!), there is DEFINITELY no widespread fear. The young bulls are as eager as they were in late 1999 to throw their capital at the capricious hands of the cruel fates. A capitulation selling panic? Baaah! Sure hasn’t happened yet! So far, the bulls seem about as panicked as a fierce lion strutting about in a petting zoo. So, since the psychological indicators of a bottom are conspicuous by their absence, we are left with valuation as our only tangible avenue to investigate the NASDAQ. Has it bottomed?
In every historical bust on record, general market P/E ratios decline to around 6 to 8 (half of the “fairly-valued” 13.5) and dividend yields surge to 6%+, rivaling bonds. NASDAQ zealots enthusiastically inform us that high-growth NASDAQ stocks typically have a “normal” P/E of 25-30, so we will reluctantly fake a concession to them that maybe a P/E of 13-15 would mark a NASDAQ bottom (F U N D A M E N T A L S is a BIG word… we don’t want to challenge and tax the primitive bullish mind too much). Of course, we don’t believe that for a minute, but for the sake of argument we will humor the thought. Cashflow is cashflow is cashflow is cashflow, whether it is spun off by an old-economy steel mill or a new-economy web-o-rama.
Has the NASDAQ bottomed in fundamental terms? Was Greenspan marking the fundamental bottom of the fledgling bear market? The graph below shows the NASDAQ composite index for the last six months as a bold blue line. The light blue lines mark daily trading ranges, representing daily highs and daily lows. The red dashed lines mark the very distinctive bear trend channel in which the NASDAQ has found itself floundering. Every month, a MARKET-CAPITALIZATION WEIGHTED AVERAGE P/E ratio is presented for the 100 biggest and most glamorous NASDAQ stocks (the venerable NASDAQ 100). The last day of the graph is the trading day before the bold Greenspan Gambit was launched on an unsuspecting world.
After digesting the graph, recall that post-mania BUST bottoms occur at half normal P/E ratios. This will be between 6-8x earnings (if history will be proven correct) or 13-15x earnings if the shiny happy NASDAQ lovers are proven correct. As the P/E numbers show, the bubble was deflating rather nicely, and panic selling is notably absent. Since the P/E ratios shown are market-cap weighted NASDAQ 100 P/E ratios, they are using the biggest NASDAQ stocks as proxies for the entire NASDAQ composite index. As of the final trading day of 2k, the NASDAQ 100 stocks were trading at a market-cap weighted average P/E of 35.7! This is almost THREE TIMES a 13x P/E NASDAQ bottom and FIVE TIMES above a historical cashflow fundamental bottom level. A simple average P/E of the NASDAQ 100 is even more damning, yielding a P/E of 80.0. The dividend yield of the NASDAQ 100 is nonexistent, weighing in at a microscopic and laughable 0.03%! Ouch.
As of that December 29, 2000 trading day, 31 of these “NASDAQ blue-chips” were losing money (no P/E) and 29 had P/Es over 50, indicating EXTREME overvaluation.
Armed with this data, it is readily apparent that Greenspan and his maties were not timing a NASDAQ bottom with the now infamous Greenspan Gambit. They chose to dangerously interrupt a totally natural and amazingly orderly deflation process. Why in the heck did they pull the trigger?
Before we discuss that, we offer one further graph of the most famous boom-bubble-burst-bust cycle in modern history. Japan 1989. The Nikkei Nightmare is graphed next to the rapidly evolving neo-NASDAQ Nightmare. The Y-axes of the graph are blown up to show detail, but the small inset graph shows the same data with complete vertical scales (NASDAQ 0-5500, Nikkei 0-42000) lest some distraught NASDAQ bull claims we contrived the comparison…
The parallels between the recent NASDAQ action and historical Nikkei 225 events are uncanny and a little unsettling. Marked by the “1”, the terminal blow-off of the NASDAQ was vastly steeper and more ballistic than the Nikkei. This is a DIRECT result of Greenspan and the boys flooding the markets with vast quantities of credit in the run-up to Y2k. Funny how some refuse to call the NASDAQ a bubble but NO ONE disputes that the Japanese equity markets were bubble-licious slightly more than a decade ago. In region “2”, the initial burst was much more damaging to the NASDAQ than to the Nikkei. The NASDAQ bubble is more extreme by all empirical measurements.
Region “3” is incredibly intriguing, as the NASDAQ made a decaying double intermediate top at EXACTLY the same timeframe and relative levels as did the Nikkei! The uncanny deja vu continues in region “4”, where the bulls began to lose a little faith and sold to salvage at least some of their capital. Region “5” witnessed a sharp V-shaped dead cat bounce in both indices, although the Nikkei showed some resilience at these levels and the NASDAQ quickly ran out of steam. Finally, region “6” shows the January 3 Greenspan Gambit in all its full glory. Which one of those bulls out there said history was irrelevant and the “new” NASDAQ was different?
Provocatively, the Nikkei 225 debacle offers some very poignant lessons for the perpetrators of the Greenspan Gambit. Today, over a decade after the fateful burst, the Nikkei still is only trading at 13,800, around a third of its bubble-top valuation. The Japanese central bankers, like Greenspan and his crew, valiantly tried to reduce the cost of capital (interest rates) to spur investor interest in the market. Their gambit failed dismally. Japanese interest rates were driven down to 0.25%, yet nothing happened. The popular analogy claims trying to reinflate a busted credit bubble is like “pushing on a string”. No matter how hard you push on one end of the string, it has zero effect on the opposite business end. Are you central bankers out there paying attention?
If low interest rates, rapidly mushrooming cheap credit, and wild-west capital arrangements could stave off a post-bubble bust, the Nikkei would be trading over 100,000 today. The Japanese reliquefication strategy failed even though the Japanese people had an enormous trade surplus, the highest personal savings rate on the planet, and relatively high consumer wealth.
If lower rates and cheap credit couldn’t help the hard-working Japanese economy, the Greenspan Gambit may as well be stillborn in the States. We Americans have the largest and most ugly trade deficit in history, our dollar is falling (which Greenspan just made MUCH worse, as will become more and more apparent in the following weeks), we have a savings rate that is LESS than zero, and most Americans have no wealth except their illiquid and overvalued real estate. Yikes!
In college anatomy class I was told that you can take a corpse, hook up electrodes to it, fire up the juice, and the dead body will dance the jig on the dissection table. (don’t try this at home kids!) Unfortunately, as soon as the electricity is pulled away from the corpse, you still have… drumroll please… A CORPSE! It doesn’t get up and walk away and is NOT restored to its former glory. Like an electrically stimulated cadaver, the Greenspan Gambit, underneath all the glitz and glamour, merely shocked a lot of temporary excitement into the NASDAQ. After the electrodes were removed, however, all that remained is the stark cold reality of a bust-in-progress.
The big hard-to-understand words for the bulls, F U N D A M E N T A L S, are horrible and deteriorating rapidly. Earnings, the only reason to ultimately own a stock, are dropping like a rock with no hope of recovery in the near future. Fear psychology is subtly starting to replace greed, one “investor” at a time. Unreal valuations cannot survive an onslaught of wavering investor faith. The interest rate cut will have zero tangible effect for at least a few months and probably more like six to nine months, and nothing has materially changed from the day before the Greenspan Gambit. (Except for the massive increase in moral hazard as Easy Al once again tells the high-flying gamblers they have nothing to fear because he will backstop all their silly trades!)
Contrary to popular opinion, the Fed is not stupid and it KNOWS that a rate cut does not change underlying ugly market fundamentals. The question that must be raised is why did they take the risk, launch the irrevocable Greenspan Gambit, and stir the pot?
Like the great generals trained in chess throughout the ages, the Fed appears to be employing strategic deception. In their public statement on the rate cut, they claimed that the slowing economy necessitated the rate cut. Market pundits speculated that the dismal Purchase Manager’s Report, with the lowest reading since the 1991 recession, prompted the Greenspan Gambit. We don’t buy it.
The Fed knows that rate cuts take many months to have a real effect. It would have made zero difference in the long run between easing at the January 31 meeting and making the flamboyant emergency move. So there must have been SOME important reason for launching the Greenspan Gambit RIGHT NOW rather than waiting a few short weeks. All the following is pure speculation, but there are several possibilities that offer explanations of this odd and aggressive behavior.
One possibility is the Fed is terrified of watching the stock market implode and stain its legacy. Greenspan and his playmates know that they flooded too much credit into the sandbox during the LTCM debacle, Russian debt crisis, and Y2k. Each time they bailed the goofy gamblers with bad debts out, they greatly increased the moral hazard in the entire US financial system. They know they have created a monster and are trying to pull off the biggest financial coup in history by attempting to abort the consequences of a bubble. This hypothesis, if true, is frightening. First, it shows that the Fed simply is catering to the stock market speculators and not worrying about the US dollar (which is plummeting as the interest rate cut made it less competitive with other currencies). Second, if the good folks at the Fed are so deluded that they think they can control the most complex economy in history by pulling levers and pressing buttons from behind their bullet-proof curtains like a command-and-control Soviet factory manager, we are all in a world of hurt. Talk about delusions of grandeur! God help the markets if this hypothesis is correct.
Arbitrarily setting the price of money is just as ridiculous as having an elite committee set up to declare by regulatory fiat what the exact price of a peanut butter and jelly sandwich will be across the nation. Pure supply and demand should determine sandwich prices, money prices, and everything in between. It is just plain dumb to “set” prices in a capitalist environment where Adam Smith’s invincible invisible hand makes all these “decisions”. The California utility regulators are learning this lesson the hard way.
Another possibility, and one we believe is far more likely, is Greenspan and his brood were aware of material nonpublic information of an impending financial catastrophe. Rumors swirled on January 3 that a major hedge fund was about to go under. Ugly derivatives stories are surfacing daily. Since the derivatives house of cards the banks have built is so faulty and fragile, even a small shock like this can create systemic tremors that threaten the entire financial system.
Out on the Left Coast in the People’s Democratic Republic of California, PG&E and Edison are facing default on their debt. They owe $2b in the next 60 days, and the REGULATED California electricity market (if it was truly UN-regulated as the socialists claim, there would be no artificial price ceiling on electricity prices!) forbids them from passing sky-high costs on to their customers. They have lost an estimated $12b by trying to survive in this government imposed fantasyland of rate ceilings. Many money market and pension funds hold this utility debt, and a default could wreak havoc within the national capital markets. This is so risky and so important that Greenspan himself had a meeting with California Governor Gray Davis last week. Bill Clinton even stopped by to offer his electricity expertise! Who would have ever guessed Greenspan was an expert on electricity?
We believe this rapidly approaching potential California utility debt default has a good probability of being material to the reason why Greenspan and the gang acted so erratically and hastily in their Gambit. The thought of low liquidity coupled with supposedly safe money-market and bond funds falling in cascading cross defaults like dominoes is enough to cause heartburn in even the most robust central banker.
Hopefully the truth will emerge in the near future, but all is NOT as it seems surrounding the Greenspan Gambit. The NASDAQ bust is NOT over, the fundamentals are STILL horrible and deteriorating, and the Federal Reserve is not disclosing the real reasons for their extraordinary move. Keep your ears to the railroad tracks on this one, but make sure your capital is safe and secure and out of the way of any yet unseen onrushing locomotive of doom.
The Greenspan Gambit is a daring strategic attempt to stave off something wicked hurtling down the financial turnpike. Will it be successful, or will Greenspan and the Fed’s opponents, whoever they may be, cry “Check Mate!” and bring the whole illusion of the financial status quo crashing down around them?
Adam Hamilton, CPA January 5, 2001 Subscribe at www.zealllc.com/subscribe.htm