Semi-Daily Journal

Ummmm, back in the Spring of 2000, there were lots of Wall Street Journal articles about how Internet stocks might be immune to Fed tightening because they were debt free . . . . . today the bogeyman is the low price of short-term money, but how much of a risk is this, really?:

"Too low a rate would imperil money-market mutual funds, for instance, because they might no longer clear enough money to cover expenses and pay a return to investors."

The U.S. needs intermediate and long-term corporate rates to fall to give an extra boost to the economy. The closer the real after expense, after tax MM rate gets to zero, the more pressure there is on MM investors to move the funds either into corporate or High Yield funds or into stock market mutual funds. Note that: (a) the MM assets will NOT go away - they'll stay in the capital markets and be invested somewhere, (b) MM mutual funds are VERY LOW PROFIT products, and (c) bond and stock mutual funds are much higher margin products.

Last, what is it with the near-total focus on the price of money these days? The Fed can target the price of money or the supply of money but not both . . . . . to get the price of overnight funds down to 0.50% may well require the addition of an enormous amount of liquidity into the system, and that's a good thing for the economy, with a lag . . .

"The closer the money market rate gets to zero, the more pressure there is on money market investors to move the funds either into corporate or high yield funds or into stock market mutual funds."

OK, but is this potentially a serious problem? Are bond and stock prices becoming high enough to constiute bubbles as several analysts are suggesting? What happens when interest rates being to rise?

http://www.nytimes.com/2003/06/20/opinion/20KRUG.html

Paul Krugman

Maybe a vigorous, though still invisible, economic recovery will deliver the sustained, double-digit earnings growth that analysts — apparently not chastened at all by recent history — are once again predicting.

But even if that happy scenario comes to pass, it's hard to justify current stock prices — because if the economy booms, the low interest rates that might conceivably make stocks worth buying at 30 times earnings will soon go away.

http://www.morganstanley.com/GEFdata/digests/latest-digest.html

Endless Bubbles
Stephen Roach (New York)

With policy makers and financial markets now fixated on the great deflation debate, it’s easy to lose sight of what precipitated this state of affairs. In my view, it’s all traceable to asset bubbles -- the excesses they fostered on the way up and the wrenching adjustments they require on the way down. The big problem with bubbles is that they tend to be contagious across asset classes -- spreading from stocks to property to bonds....

Defined the Krugman way, stocks can never go up.

He's smart enough to know better, but some internet virus seems to snuck past his subcranial firewall and infected his brain. So, stocks can't go up now because earnings are way, way down - and even if earnings are going to rise in the future, then interest rates will go up so fast that stocks still shouldn't rally. Please.

Sure the stock market is expensive by historical standards, but it's also true that during recessions stocks tend to have abnormally high P/E ratios because earnings are cyclically depressed, and because stocks try to discount the future - and in this case, I think the stock market rally is correctly anticipating an economic recovery of considerable strength beginning in late 2003 or sometime in 2004.

And the Fed's next move is likely to be an EASE. That means lower interest rates, so the TREND IN SHORT RATES IS STILL DOWN. Yes, absolutely, interest rates normally rise during a recovery as capital spending and consumer demand kick in - but in moderation, that's still a good thing. Especially with decent productivity growth continuing at above-average rates, inflation is less likely to be a problem in 2004 or 2005.

Assuming that the size of the money-market funds is severely reduced by further Fed cuts, it is certainly true that the money will still exist and most of it will still be in the financial markets someplace, but one possible problem is that a large portion of commercial paper is purchased by money market funds--to the extent that they can't do that, issuers, mostly very large corporations, will have to turn to higher-cost sources of funds (banks, probably), possibly actually causing their cost of funds to go up, and in any case reducing the benefit of the rate cuts.

If we already expect "an economic recovery of considerable strength beginning in late 2003 or sometime in 2004", then this cut is almost certainly a mistake. I don't happen to expect that, but I still think this is a mistake as the economy already has too much liquidity flowing into asset markets, and this is probably going to increase imbalances in the economy. I don't see a happy resolution in any case, but this may just extend the pain.

People might be interested in this paper:

http://www.frbsf.org/publications/economics/letter/2003/el2003-17.html

about the prospects for growth.

anarchus, it doesn't take a virus to make you think the way that krugman does - i believe the same thing. You slightly misstate or misunderstand what he wrote.

The argument that stocks are worth a P/E of 30 is a low-interest rate argument. But long rates will not indefinitely fixate upon deflation as the problem d'jour. Should profits jump (which neither krugman nor i expect), the long market will suddenly take into account the endless deficits, the fear of crowding out, the weakness of the dollar, and discount more risk than they currently are.

And when they do, the argument for a P/E of 30 goes away. Thus, we could simultaneously see profits improving and P/Es falling to more typical levels.

Neither you nor I nor Krugman knows for sure what is going to happen, but it's not like it's hard to figure out what Krugman's worried about.

The stock market is essentially a pyramid scheme - the more money that goes in, the higher it goes. It's a self reinforcing cycle, until the money runs out.

Suppose we take a look at the work of Jeremy Siegal and Robert Schiller and trace price/earning ratios through the century. Though the stock market may certainly rise significantly from here, I find no reason to believe that a p/e above 30 for the S&P and above 200 for the NASDAQ is not a danger sign.

Price earning ratios never have risen to anything like the present level during recessions, though during the depression they did since earnings declined and turned negative. This is an expensive stock market, though it may well rise from here. Warren Buffett and Charles Munger have also been warning about these valuations. No matter, invest away.

When Paul Krugman warned about valuations in Asia before 1998, it paid to pay attention. When Krugman warned about stocks in early 2000, it paid to attend. When the warning was about AOL-Time-Warner, it paid to attend. So, buy EBay or Yahoo and hope they become Wal-Mart and Disney.

"If we already expect 'an economic recovery of considerable strength beginning in late 2003 or sometime in 2004', then this cut is almost certainly a mistake. I don't happen to expect that, but I still think this is a mistake as the economy already has too much liquidity flowing into asset markets."

This is just the argument of Stephen Roach. Federal Reserve policy has been counting on liquidity flowing into asset markets to support consumer spending through this most unusual economic slowing. So, have we traded a stock market bubble for bubbles in housing or bonds? Besides, stocks really are still expensive.

Should we worry about Federal Reserve policy? Remember, Alan Greenspan was worried about a budget surplus in 2001, and supported tax cuts that will insure fierce deficits as far as can be seen.

By the by, with the exception of Vanguard funds or index funds, mutual funds are quite high priced and cost investors a good deal of returns that should be theirs.

One side of the argument over the direction of the economy and markets has a sort of "no way out" quality to it lately. The standard cure for slow growth - easier Fed policy - is wrong because it doesn't allow "wringing out". Stocks won't be able to rise because bond yields will rise, thereby boosting the cost of doing business and cutting earnings prospects. Productivity growth, which represents the potential for higher margins and higher wages, is bad because it slows employment growth.

Doesn't this "no way out" come down to an assertion that the self-correcting mechanisms in the economy aren't doing their job? In addition to policy efforts, the weaker dollar and wage restraint are both textbook sorts of helps to a sick economy (though benefits costs are a problem). Typically, the US economy grows under its own power, reflecting rising productivity and a growing workforce. You have to make the claim that there is a deep underlying problem in the economy to argue that monetary and fiscal prescriptions that have worked in the past will fail now. Much of what has ailed the US economy over the past couple of years looks to me to be a series of shocks, with the economy proving more resilient than many (including Chairman Greenspan) would have guessed. I understand that when the economy is weak, bad events manifest more strongly as "economic shocks", so may not be that hard to come by. Still, If we don't suffer another SARS/Enron/bin Laden/Iraq, isn't history on our side?

For what it's worth, the UBS/Gallup poll of US investor sentiment hit a 13-month high in June. Is that good or bad?