Editorial comment: Dr Greenspan's wonder drug Published: January 5 2001 20:04GMT | Last Updated: January 5 2001 20:08GMT Was it a stimulant or a depressant? The market in US technology stocks responded to Alan Greenspan's half-point cut in interest rates with a wild whoop of "Yippee!". But after the 14 per cent surge in the Nasdaq Composite index on Wednesday there was a rapid descent into cold turkey. Despite a general hope that the US Federal Reserve chairman will soon administer another fix, the markets have been drifting down again, amid anxieties of what a chill in the US economy would do to profits and dividends. Friday's employment figures were not especially gloomy, but the unexpected steepness of the Fed's cut showed that it is really worried that the economy may soon slip from hyperactivity into a dangerous torpor. For investors, the question must be whether Mr Greenspan can - or will - lower rates enough to prevent a serious slide in stock prices. There are two kinds of answer to this question. The first is from the Fed's perspective. Mr Greenspan has repeatedly indicated that it is no part of his job to rescue investors from their folly, if they have bid up share prices to unsustainable values. But at the same time the Fed has a strong interest in avoiding a panic sell-off that could damage consumers' confidence and so push the economy into an unnecessary relapse. Since the Fed has shown now - as in 1998 - that it is prepared to act pre-emptively to restore financial confidence, investors may judge, as they appeared to do on Wednesday, that they can breathe more easily. But aside from confidence, the Fed still needs to ensure that the economy slows down after four years in which growth has averaged 4= per cent a year, well above the rate that even the optimists consider to be sustainable. Unemployment has almost halved in the last eight years, to 4 per cent, a level that by historical standards is close to the danger zone of inflationary pressures. And inflation has been rising in the last two years. Low annual rate It is true that this was from a remarkably low annual rate of 1.4 per cent in early 1998; it is true also that part of the reason for the rise was the run-up of oil prices this year. But the tightness in the oil markets reflected the extra demand from a rumbustious US economy. So from all points of view a slowdown was needed. If one considered only the real economy, a very rapid slowdown - resulting in little or no growth in the early part of next year - would not do very much damage provided it did not last too long. The medicine would be unpleasant, of course, particularly for those who were laid off. But like a patient who has had a scare, business investors might take things easier after the recovery got under way. Company profits Unfortunately for stock-holders there is another perspective. Historically, company profits have reacted in a highly emphatic way to relatively modest changes in underlying economic growth. In 1979-80, for example, as the economy turned down, real profits shrank by more than 30 per cent; but they recovered by 45 per cent between 1983 and 1984. And this was not exceptional. There has been a pattern of spikes and troughs throughout the last half-century. The 1990s were exceptional only in that real corporate profits sustained a steadier rise of about 10 per cent a year up to 1997, while the fall in profits during the 1998 financial wobble was only a modest 3 per cent This rise in profits was sustained by a tripling of earnings in the companies in the Standard & Poors 500 index in the last eight years, a period in which US gross domestic product rose by "only" 50 per cent. Stock prices, however, rose even faster than earnings - by more than 4= times in the period, presumably because the markets expected the trends of the 1990s to continue. A period of convalescence for the economy would cause that assumption to be reconsidered - as the halving of the Nasdaq since last year's peak vividly suggests. For investors who take a long view two facts stand out. The rapid rise in profits as a share of gross domestic product in the 1990s has far from redressed the balance of the fall in the 1970s. Profits are still only about 8 per cent of GDP compared with about 10 per cent in the 1950s and 1960s. Through another prism it appears that the average rise in profits over the last 30 years has been about the same as the growth of GDP. The acceleration in the 1990s may seem a catch up from the fall in the 1970s. Even if the recent surge does reflect the impact of new technologies, the 9 per cent rise in profits that US analysts expect for next year could look extremely optimistic if GDP growth slows to 1 or 2 per cent. So whatever dosage Mr Greenspan thinks appropriate for the economy may prove too little too late for the health of the markets. _______________________________________________ Crashlist website: http://website.lineone.net/~resource_base
