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Prelude to a Rally

The Dow and the S&P are looking like scorched earth, but this portends a rally, not a bear market.

The beneficial influence of fire in nature and the market has long been recognized. Certain species of pine trees will only shed their seeds if fire passes through. By clearing out the underbrush, the stage is set for pines and other good trees -- and stocks -- to climb.

Fire has been raging through the stock market for the past six weeks. The

Dow Jones Industrial Average

closed Friday below 10,000 for the first time in 10 months, down 16% from its 2000 high. Of the 88 industry groups in the

Standard & Poor's 500

, shoes, containers, engineering and construction, hotels, retailers and life insurers are down 33% or more in the first two months of the year. The six consecutive Friday declines in the S&P 500, culminating in the 17-point drop last Friday, have been distressing, particularly with the very volatile employment number scheduled for release at the end of this week.

Certain analysts are noting that there's some real pain out there, and other analysts who have been on the wrong side of 95% of the moves in stocks over the past 10 years are now bearish again.

The pine trees may be ready to grow, though. Recall that in 1999, the S&P gained 21% and bonds lost 13%, a divergence of 35 percentage points.

The situation is now the reverse. Year-to-date, bonds have gained 4.4%, vs. a 9% loss for the S&P 500. Just in the first two months of the year, the spread has narrowed by 40%.

This is the reverse of what triggered the 1987 crash. During the first horrible nine months of 1987, stocks rallied 36% and bonds declined 20%.

Where are those bullish gurus now to ballast the Cassandras who for 11 years have been singing the stock-bond blues? Times like these are very healthy, and a buying climax is near. It is good to remember on these occasions the words of


: "Omni qua secundum," or "The ways of nature are always good."

Broken Record

The 56-percentage-point divergence between stocks and bonds was the fundamental cause of the 1987 crash. The proximate cause, however, was



James Baker

, who arrogantly told the Germans that he was going to bury the dollar unless they boosted the German economy. "Baker did it," explained


President Otto Pohl, one day after the crash.

While the former secretary now presumably has gained some humility for his role,

Federal Reserve


Alan Greenspan

is presumably pleased with the reduction in wealth he has wrought.

The market could use a Cicero much more than it could Greenspan at the head of the Federal Reserve. Greenspan's theories about the links between analysts' earnings expectations and stock prices, and consumption vs. supply are so ad hoc, so out of line with the current understanding of rational expectations that all economics students are expected to possess, and so out of sync with the findings of the behavioral-finance types, that it would be wasteful to dignify them with criticism. As

Dr. Johnson

might say, "Such a man could count the grains of wheat in a bushel if he had a scale."

The abject servility with which economists and politicians have greeted Dr. Greenspan's untested assertions tells more about the pervasive influence of incentives and self-interest on economists than the bankruptcy of the profession. After all, if half of the theorists in a particular field in monetary economics have been, are or will be receiving stipends from the Fed for their work, it is hard for them to dismiss these ramblings with the same intolerance that they would show toward a student's paper with similar rambling tendencies.

Nevertheless, as a service to the profession and our readers, we will record Dr. Greenspan's warnings on the stock market, in his own manner and style, along with their revisions and the contemporaneous levels of the Dow and



Dec. 5, 1996:

Speech on "The Challenge of Central Banking in a Democratic Society," presented at an awards dinner sponsored by

The American Enterprise Institute for Public Policy Research


DJIA: 6437; Nasdaq: 1300.

And how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?

Feb. 26, 1997:

Humphrey-Hawkins testimony to the

Senate Banking Committee


DJIA: 6983; Nasdaq: 1340.

As you know, last December I put the question this way: "How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions...?" We have not been able, as yet, to provide a satisfying answer to this question, but there are reasons in the current environment to keep this question on the table. Clearly, when people are exposed to long periods of relative economic tranquility, they seem inevitably prone to complacency about the future. ... History counsels caution. Such caution seems especially warranted with regard to the sharp rise in equity prices during the past two years. These gains have obviously raised questions of sustainability.

July 21, 1998:

Humphrey Hawkins testimony to the

House Banking Committee

, Q&A.

DJIA: 9190; Nasdaq: 1979.

A significant part of the rise in equity prices has resulted from a continuous increase in long-term expected earnings, starting from evaluations of security analysts in early 1995, virtually continuously since. They have raised their long-term expectations virtually month after month and their current level, which is well over 13 percent annual rate, if projected indefinitely in the future, projects a very marked rise in profit margins and the share of profits in the national income. History tells us that that is going to run into some difficulty sooner rather than later, which suggests that these three-to-five-year projections of analysts are unrealistic and that the real world will somehow converge and suggest that to them in no uncertain terms.

Feb. 23, 1999:

Humphrey-Hawkins testimony to the Senate Banking Committee, Q&A.

DJIA: 9366; Nasdaq: 2376.

Whether or not it's gripped by irrational exuberance is an issue that you won't really know for sure except after the fact. But as I indicated in my prepared remarks, that I suspect that these markets are highly valued leaves me without terribly much doubt at this point.

May 6, 1999:

Speech at 35th Annual Conference on Bank Structure and Competition of the

Federal Reserve Bank of Chicago


DJIA: 10,946; Nasdaq: 2472.

The breadth of technological advance and its application has engendered a major upward revaluation of business assets, both real and intangible. That revaluation has induced a spectacular rise in equity prices that to many has reached well beyond the justifiable.

June 17, 1999

Speech to

Congress' Joint Economic Committee


DJIA: 10,841; Nasdaq: 2544.

A benign economic environment can induce investors to take on more risk and drive asset prices to unsustainable levels. ... The 1990s have witnessed one of the great bull stock markets in American history. Whether that means an unstable bubble has developed in its wake is difficult to assess. A large number of analysts have judged the level of equity prices to be excessive, even taking into account the rise in "fair value" resulting from the acceleration of productivity and the associated long-term corporate earnings outlook.

July 22, 1999:

Humphrey-Hawkins testimony to the House Banking Committee, Q&A.

DJIA: 10,969; Nasdaq: 2684.

A significant part of the rise in prices reflects rising expected earnings, and a goodly part of that is a very major change in the view of where productivity is going. What we do not know is whether it's being overdone or to what extent it's being overdone. I've always said I suspect it is, but firm, hard evidence in this area is very difficult to come by.

Feb. 17, 2000

Humphrey-Hawkins testimony to the House Banking Committee.

DJIA: 10,514; Nasdaq: 4548

These safety valves that have been supplying goods and services to meet the recent increments to purchasing power largely generated by capital gains cannot be expected to absorb an excess of demand over supply indefinitely.

Laurel Kenner is a former markets editor of Bloomberg, and a trader. Victor Niederhoffer is currently a private investor and author of Education of a Speculator. At time of publication, Kenner was not long any of the issues in this column, while Neiderhoffer held a net long position in S&P 500 futures and options, although positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While they cannot provide investment advice or recommendations, they invite you to comment on this column at