The Cooked-Frog Economy

How do you cool off a hot economy and stock market? Ask Alan Greenspan; it's just like cooking a frog.
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Editor's Note: With this column, we introduce David Ricardo, the pseudonym for an investment professional. As always, tell us what you think.

The stock market's recent behavior is reminiscent of an ancient high school biology experiment involving frogs that is probably no longer allowed in today's politically correct world. Frogs, of course, are highly adaptive, cold-blooded amphibians. Our old experiment calls for throwing a frog into a pot of boiling water and then watching it instinctively jump out of it.

In the next phase, the frog is thrown into a pot of tepid water and it is more than happy to swim around in it. Here the experiment gets interesting. While the frog is swimming around, the heat is gradually increased. As the water temperature rises, the frog adapts. However, as the water temperature approaches the boiling point, the frog can no longer adapt; it is cooked.

In the stock market we have our very own biology teacher in the person of

Fed

Chairman

Alan Greenspan

, who, in response to a white-hot economy, is gradually ratcheting up short-term interest rates or shifting the so-called bias. The Fed raised the all-important

federal funds rate

by 25 basis points in late June and again in mid-August. Although investors squirmed a bit each time interest rates were turned up, they instantaneously adapted to the new rate structure and bid stock prices higher. Steve Roach,

Morgan Stanley's

chief economist, would later characterize the Fed's moves as "easings." Moreover, when the Fed adopted its tightening bias in early October, stocks once again rallied.

After all, on all three occasions, the Fed used calming language in depicting its policy stance. More important, most investors came out swimmingly well after last fall's stock-market downdraft. That was precipitated by what many serious observers called the worst global economic crisis in nearly 60 years. If market participants could quickly recover from the heat of such a maelstrom, what's a meager 50-basis-point increase in the federal funds rate?

Surely, they reason, the best U.S. economy in a generation, or perhaps ever, could withstand a modest hike in interest rates -- especially if it is in the name of short-circuiting an incipient inflation trend before it takes hold.

Moreover, the emerging consensus appears to be that as soon as any hint of moderation in economic activity appears, the Fed would put in abeyance any plans to raise interest rates. That consensus was validated when stocks rallied sharply on Sept. 2 and Oct. 8 in response to weaker-than-expected employment reports. Nevertheless, what most market participants refuse to recognize is that the very act of standing firm in the face of rate hikes, and rallying sharply on very tentative signs of moderating growth, means they are adding fuel to the fire that will ultimately consume them.

How so? At its very core, the economic boom we are now enjoying is being propelled by ever-rising stock prices that are simultaneously providing the fuel for increased consumer spending through the wealth effect, and higher corporate investment through the ease of equity finance, especially for new companies. Therefore, by failing to decline -- and in fact rallying in the face of higher interest rates -- the stock market probably provided

more

stimulus to the economy than the Fed was trying to take away. Thus, it appears to this writer that, before the experiment is completed, interest rates will probably end up much higher than the deeply pessimistic bond bears would now find credible.

The Alan Greenspan Fed is gradualist in nature; it rarely moves 50 basis points at a time, and next month, we'll probably get another 25 basis points. Just as in the frog experiment, the Fed's gradual pressure on a very adaptive economy and stock market will at first be hardly noticed. But make no mistake about it, the Fed's actions are cumulatively putting pressure on the stock market.

Thus, I suspect, the orderly 524-point one-week decline in the

Dow Jones Industrial Average

in late September and this week's two-day 416-point plunge could just be a foretaste of what would occur after several more rate hikes. The climate will have changed, and with that, the stock market and the economy would start taking on some of the aspects of our dead frog.

David Ricardo is the pseudonym of an investment professional. He can be reached via

commentarymail@thestreet.com.