Exuberance Inches Back, Irrational or Otherwise

Since the beginning of the year, the Federal Reserve has added a record amount of cash to the U.S. money pool. What are the chances it's been enough to blow another stock market bubble?

While the major averages are still below their levels prior to the terrorist attacks, volatility has been high and the recent move to the upside has had characteristics of the big moves of 1999 and 2000. The Nasdaq saw its biggest spike since April on Wednesday and is up 12.3% since Sept. 21. It's the kind of momentum that would've had the bulls piling in several years ago.

A Lot of Help From the Fed

Back in 1998, the Federal Reserve lowered interest rates three times and by 75 basis points in response to the Long Term Capital Management hedge fund debacle and the Russian debt crisis. At the time, the U.S. economy was thought to be in deep trouble. "This is the worst financial crisis of the last 50 years," President Clinton said in October 1998. But in the two years following his statement, the Dow Jones rose more than 3000 points, or 40%. The Nasdaq gained close to 2000 points, or 117%.

Fast-forward: The Federal Reserve's ax is sharper than ever. So far this year, the central bank has cut short-term interest rates nine times and by 350 basis points to their lowest level since President Kennedy was in office, seemingly with good reason. "The terrorist attacks have significantly heightened uncertainty in an economy that was already weak," the Fed said in a statement following its latest reduction on Oct. 2.

The similarities between then and now are interesting, although the differences are noteworthy, too. "In 1998, it turned out the threat to the U.S. economy was much less than expected," said David Orr, an economist at First Union. "In hindsight, the liquidity was more than necessary. But this is the real deal." In most senses, the economy was better off in 1998: Unemployment was down, car sales were up, air travel was on the rise, and corporate profits were not yet dropping.

Another Bubble?

Still, the fact that there is so much liquidity in the banking system has experts thinking. "They are providing the money necessary for a bubble," said Tony Crescenzi, chief bond market strategist at Miller Tabak, who is nonetheless skeptical of one being formed. M3, a measure of the money supply, has risen 13.8% in the past year, the fastest rate of increase since the 1970s.

There is more than $5 trillion in money market funds, savings, and CDs, with the yields on these accounts being 2% to 3%. (It would be negative after tax and after inflation.) "If that money is transferred into the real economy or financial assets," said Crescenzi, "you could get froth."

Some investors have reported paying only 3% to 3.5% interest on big margin accounts, which might encourage stock investing. Margin debt has fallen with the collapse of the market this year, however. Latest figures show it's down to $160 billion from $280 billion last year.

Rosy Time for the Hedges

Another way Fed easing could boost the stock market is via Treasury market plays. Some hedge funds have been piling up huge profits in the past few weeks on what has amounted to an almost sure bet that the spread between the yield on short- and long-dated maturities will widen. The wager, which began following the terrorist attacks on the assumption that investors would seek the safety of 2-year Treasury notes as rates came down, has been paying off and is said to be one of the reasons the government made an unscheduled sale of 10-year notes on Thursday.

While the so-called steepening play does nothing for stocks in and of itself, there's been speculation that when it's played its course, hedge funds will need somewhere else to put their newly minted cash. Flows like that, if they found their way back into equities, could be the basis for a renewed bull market.

Although the Dow has tumbled 16% and the Nasdaq has fallen 35% this year, experts say that monetary policy has brought stock market prices higher than they would be otherwise. "Without the Fed, valuations would be lower," said Mickey Levy, an economist at Banc of America Securities. "But the heightened potential for international conflict should keep price-to-earnings multiples suppressed."

In the end, experts seem to agree that this year's rate cuts were worth doing, even if there is a risk of another bubble. "The mistakes of overdoing it costs less than the mistake of not doing enough," said Orr. "The Depression happened once, between 1930 and 1932, because there was not enough liquidity. I wouldn't want to see that happen again." Even if it means going too far in the opposite direction.