meeting scheduled for Tuesday afternoon, all eyes will likely shift back to Chairman Alan Greenspan and company. The last time the group met, it voted to reduce the federal funds rate by 50 basis points, the 12th cut since January 2001. The series of rate cuts was intended to help jump-start the sputtering U.S. economy, but the Fed is expected to stand pat on interest rates this week.
With stock prices now falling and the
Dow Jones Industrial Average
tumbling 500 points in just five trading sessions, some worried investors are wondering whether the "Greenspan Put" is set to expire.
As the nation's central bank, the Fed is in charge of conducting U.S. monetary policy and helps smooth out bumps in the economy through a combination of open-market operations (the buying and selling of Treasury securities) and changes in interest rates. For example, in reaction to an economic recession and the Sept. 11 terrorist attacks, the Fed cut rates 11 times last year. The Fed slashed the fed funds rate from 6.5% to 1.75% in 2001 and lowered it again Nov. 6 to 1.25%.
Although the Fed directs its policy at the economy and not at the stock market, investors generally view lower interest rates as a positive for share prices. Lower interest rates add liquidity to the system, so each rate cut is like a liquidity infusion that eventually finds its way into the stock market.
Some market watchers believe that the Fed uses interest rates to avert market crashes. Two recent episodes have prompted this notion: the market crash of 1987 and the liquidity crunch of 1998. Both instances caused the Fed to lower interest rates and pump liquidity into the system. Both also resulted in the stock market's rapid recovery.
Because the Fed sometimes intervenes during periods of market mayhem, the central bank is seen as a protector in the event of a market collapse. In fact, some use the term "Greenspan Put" to describe this phenomenon. A put is a type of option contract that increases in value as the market moves lower. Puts are often used as protection or hedges. For example, a fund manager who holds a large portfolio of stocks might buy puts to protect that portfolio. If the market falls, the value of the portfolio will probably drop, but the put will increase in value. This is known as a hedge. Some view the Fed's willingness to step in and help protect the market in the event of a crash as a put option. The term became popular during Greenspan's tenure.
Given that the Fed has been lowering interest rates since January 2001, and stock prices have been heading south during most of that time, investors are beginning to question the efficacy of the Greenspan Put. In the face of weakening economic conditions and deteriorating corporate profits, even the 11 rate cuts last year failed to revive the U.S. stock market. Therefore, can investors really count on the Fed to halt falling stock prices?
If they can't, then it adds another element of risk that is perhaps not yet priced into stocks. On Dec. 6, Merrill Lynch analyst Richard Bernstein shook up the market with a research piece titled, "Why the Equity Markets May Still Be 'Highly Speculative.'" In that note, Bernstein recommended that clients trim their exposure to stocks, partly because of the Greenspan Put.
According to the strategist, "We have written many times regarding the 'Greenspan Put,' or the idea that the market has unlimited upside and limited downside when the Fed eases. We have noted that the Greenspan Put has become a 'moral hazard' issue within the stock market because investors take more risk than they normally would because of the perceived safety net provided by the Fed. The market's recent rally seems to confirm that the Greenspan Put is alive and well."
If investors have put too much faith in the Fed and eventually recognize that reality, it could provide a catalyst for another downturn in the stock market. Investors would be less willing to take on risk, creating a growing sense of risk aversion. In that event, stock prices are likely to fall.
Furthermore, given that the Dow Jones Industrial Average has suffered a 500-point decline during the past five trading sessions, Tuesday's (and future) Fed meetings take on even greater importance. Although the Fed is not expected to change interest rates, the wording of its statements as well as hints about future direction of monetary policy can have an important effect on investor confidence.
By Frederic Ruffy, senior writer and index strategist at