Tough Love: Greenspan Does the Right Thing by Not Giving In to the Market

By damping -- if not killing -- expectations for an intermeeting rate cut today, Federal Reserve Chairman Alan Greenspan probably ruined his chances of being invited to the home of Bear Stearns economist Wayne Angell anytime soon. Greenspan also didn't ingratiate himself with most folks on Wall Street, who expressed their displeasure by sending the Dow Jones Industrial Average down 1.3%, the S&P 500 off 1.4% and the Nasdaq Composite off 2.5% to 2151.83.

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The Comp fell 22.4% in February, its third-worst month in history. The S&P 500 fell 9.2% for the month, its worst since August 1998. The Dow fell 3.6%.

But by not giving the market what it wanted (for a change), Greenspan did the right thing -- even if it resulted in more short-term pain for most investors. Perhaps, like some troubled children, the market realized it needed some discipline and responded positively (albeit mutely and delayed) to the paddling. At 10,495.28, the Dow closed about 70 points above its intraday low, while the S&P 500 closed at 1239.94 vs. its nadir of 1229.65. The Comp's session low was 2127.50.

Had Greenspan suggested an intermeeting rate cut was imminent (and it may yet occur), a short-term rally would have resulted, but one ultimately doomed to fail -- as was the advance following the Fed's intermeeting cut on Jan. 3. Market participants would have then returned to the Fed once again, hat in hand. Every time the Fed participates in this dance, it reinforces the moral hazard dilemma, and risks losing more credibility. The really scary scenario occurs when investors totally lose faith in the Fed's ability to stem declines, economic or market.

"Greenspan is being sensible, and his approach to monetary policy is even-handed and reflects conditions that don't necessitate a panic," said Doug Kass, general partner at Seabreeze Partners in Palm Beach, Fla. "In a perverse way, I view his inaction positively as it implies a more solid economy than previously thought."

In fact, even as the meltdown scenario described here this morning seemed to be coming to fruition, Kass, a hedge fund manager, lowered the odds it will come to pass to 20% from 40%. (And, I swear, he was saying this as the market was trading at its intraday lows.)

"I like the action. If [the nightmare scenario] was to happen, it might have happened today in light of Greenspan's testimony," he said. "If the market can hold, we might be out of the woods for some time. The chance of a gradual meltdown remains, but not the nightmare scenario. A quick and vicious drop seems less likely." (To recap: The meltdown scenario calls for steep stock losses leading to a vicious cycle of more extreme losses as tech-focused funds face redemptions.)

Kass reiterated a belief that if the meltdown doesn't unfold, a sustained bottom will emerge. But other previously skeptical market watchers don't share the optimism.

Still No Bottom, but Opportunity

"I honestly believe there's still more downside to go," said Brett Gallagher, head of U.S equities and deputy chief investment officer at Julius Baer Investment Management, whose "no bottom" call on Nov. 30 was prescient.

"No question, the Fed is going to lower rates and eventually that does plant the seeds of recovery," Gallagher said today. "On the other hand, you've got earnings that are weak, negative surprises that are becoming more the rule, and it's likely that is going to hold sway for the next three to five months."

Gallagher's group runs more than $5 billion, including the flagship (BJBIX Quote)Julius Baer International Equity fund, and a $400 million core U.S. equity portfolio that rose 4.3% last year. He remains concerned because of a belief that analysts' long-term earnings estimates for tech companies remain far too rosy. (Yes, those are the same analysts on which Greespan relied for his long-term optimism.)

The three-to-five year median earnings-growth estimate for the S&P technology sector is 24.7%, according to Joseph Kalinowski, equity strategist at Thomson Financial/First Call, who said the estimate has been above 20% since January 1998.

"Earnings are going to look worse than investors currently expect," Gallagher said. Even as analysts revise down estimates for the current year and 2002 (in some cases), "the long-term growth figures have barely budged," he continued. "They'll have to be adjusted before we see an ultimate bottom."

That said, the money manager compared the recent selloff to Asia after the currency crises there, when "people were just placing ridiculous values on very good companies."

Julius Baer Investment Management currently has about 15% of its equity assets in tech stocks, but that's up from around 10% in November. There are "compelling values" in some mid-cap tech names, Gallagher said, citing Teradyne (TER Quote), Compuware (CPWR Quote) and Parametric Technology (PMTC Quote) as examples.

Julius Baer is long all three -- so much so that Gallagher said he'd be reluctant to add more. But he "would buy more for my personal account."

Consumer staples have long been the fund group's biggest sector exposure, with long positions including Philip Morris (MO Quote), Kimberly-Clark (KMB Quote) and PepsiCo (PEP Quote).

The valuations are "not as compelling now" as six months ago, he said, but the group remains "fairly low-risk."

More recently, Gallagher has been "dipping into" basic industry plays, including Lyondell Chemical (LYO Quote) and Dow Chemical (DOW Quote).

The fund manager doesn't believe an upturn is imminent and wouldn't take an "oversized" position, but believes chemical makers will generate positive returns over then next 18 to 24 months.

Greenspan Fricassee

Anytime I've written critically about Alan Greenspan (something I've done lately with frequency bordering on obsession), readers inevitably email to chide me for omitting Greenspan's biggest gaffe: His overzealous tightening in 1999 and 2000, particularly the final 50 basis-point hike on May 16, 2000.

To anyone planning to email with the same point in the future, please consider the following: Yes, the Fed overshot in its tightening efforts last year. But you cannot start the clock when the Fed started to raise rates in June 1999. In the view of most Greenspan critics, the tightening effort was in response to the Fed's overly aggressive easing in the fall of 1998 and opening of the monetary floodgates in late 1999 in response to the Y2K "threat."

The recent "cycles" suggest it is unlikely Greenspan will now be able to use as blunt an instrument as monetary policy to "fine-tune" the U.S. economy. Furthermore, if investors benefited from Greenspan's errors on the one hand (and they did), it's a little unfair for them to complain when his mistakes hurt on the other.

That's like cooking the goose because it stopped laying golden eggs.