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Humphrey-Hawkins Shows Greenspan Still Nervous About Stocks

Stocks will have to slow considerably for the economy to land on its feet, says the Fed Head.

So this is how it will happen:

The demand for capital created by rampant economic growth will push real interest rates higher. Higher rates will prompt investors to sink more money into the higher-yielding stock market. Stock market gains will raise consumer spending, which will cause more economic growth and more demand for capital. Finally, real rates, with the help of an aggressive

Federal Reserve

, will go high enough to slow growth to a manageable pace.

Oh, yes. And in the meantime, stock market returns will fall to anemic levels.

Fed Chairman

Alan Greenspan

laid out that soft-landing case today in his

Humphrey-Hawkins testimony before the

House Banking Committee

. Greenspan, who has been getting increasingly explicit about the stock-market's contribution to consumer spending, told the committee members:

Other things equal, this condition will involve equity discount factors high enough to bring the rise in asset values into line with that of household incomes, thereby stemming the impetus to consumption relative to income that has come from rising wealth.

Greenspan was careful to note that these "equity discount factors" need not cause an outright crash in stocks or real estate. They need not even cause a decline. The soft-landing scenario merely requires that returns slow to the level at which personal incomes are growing.

That's a little under 6% annually, well below long-term historical norms, and low enough to scare the

JDS Uniphase


out of any investor acclimated to the 14.9% return the

Wilshire 5000

has been averaging since 1985.

"So that's the new speed limit for the stock market," interprets Paul Kasriel, chief U.S. economist at

Northern Trust Co. of Chicago

. "Anything greater than that creates too much demand and has the potential for higher inflation."

There are a lot of stocks that wouldn't mind a 6% return. A broad assortment of drug, financial, cyclical and consumer stocks have struggled since the Fed started raising interest rates last summer. And the smaller those stocks have been, the worse they've performed.

But you don't have to own

Protein Design Labs


on margin to understand that Greenspan isn't talking about those sorts of stocks. In general, the white-hot technology and biotech sectors have yet to respond to the Fed's tightening.

That's not to say that they never will, though. "One of the biggest things driving the unusually high multiples is the fact that the earnings growth really is there," says Jeffrey Warantz, equity strategist at

Salomon Smith Barney

. "If we see real rates rising, and if that becomes a limiting factor on earnings growth, it's very likely that this could be a braking force on some of these highflying stocks.

"The multiples are being paid for the growth. If you hold back the growth, you'll hold back those prices."

Earnings growth is one thing. Momentum is quite another. Whether the fed funds rate sits at 6%, 6.25%, or 6.5%, the opportunity cost of missing a 200% annualized return on equity is prohibitive. To stop the wealth effect, the Fed will have to get more aggressive than it has been in the recent past.

But few expect that sort of vigilance from the chairman. "Until we get some core-inflation flare-ups," says Kasriel, "he's going to continue to go to the economy's body. Jab a little bit, but not throw a haymaker. He'll just try to wear it down with 25 basis points every meeting, or every other meeting, until he sees some signs that this thing is weakening."

The ultimate end of the Fed's intensifying verbal campaign against the wealth effect is far off. But Day One of Humphrey-Hawkins hasn't forced any technical analysts to redraw their trendlines. The

Nasdaq Composite Index

gained 121.25, or 2.7%, to a record high of 4548.90, while the

American Stock Exchange Biotechnology Index

rose 52.4, or 8.7%, to 658.0, also a record high.