Irrational confidence

Don't count on the 'Greenspan put'

Jeff Sanford
Financial Post

After three months of good advances in North American markets, investors seem ready to pack the bear in a box and bury it.
Good idea?

Absolutely not, says Paul Weller, a professor at the Tippie College of Business at the University of Iowa. He suggests in a recent paper, written with two colleagues, that a significant bubble still underpins the entire Standard & Poor's 500 -- a bubble, says Prof. Weller, most improbably, the result of Alan Greenspan's stellar job performance.

According to Mr. Weller, investors were so impressed by the Fed's ability to prevent a market break in 1987 and its agility in negotiating the credit crunch of 1998 that an irrational perception has developed among investors that the Fed can successfully negotiate any form of market turbulence.
As a result, investors have discounted the risk in the stock market, a phenomenon Mr. Weller calls the"Greenspan put."

"In some sense what happened was that he was doing his job too well and he came to be viewed as somebody who could do more than he actually could."
Investors have been lulled into believing that Mr. Greenspan would insure against downside risk in the market. That's where the"put" comes in. (A put is an option that gives the holder the right to sell an underlying security at a fixed price, insuring against a decline.)
"The effect of this misperception, this irrational belief, would operate like having a put option on the market," says Mr. Weller."But of course the reality is that there's a bubble because this put option will not exist when it actually comes to be exercised."

Mr. Weller says Mr. Greenspan appeared to have concerns the market was overvalued when he made his"irrational exuberance" speech in 1996. But the Fed chairman never followed through in addressing his concerns."In fact, quite the reverse. He seemed to undergo a conversion towards a belief in the so-called New Economy, which he seems to have not recanted on." Mr. Weller claims the fallout had a damaging effect by further boosting the market and leading to even greater overvaluation.

"In our view, he did too little to convince investors that the asset bubble was based on irrational optimism and irrational belief in his own superhero powers." As proof, Mr. Weller points out that the risk premium in the U.S. stock market (the premium investors pay for stocks to compensate for their increased risk over bonds) has been on the decline for some time, suggesting investors don't think stocks as risky as they used to be.
Not that the real risk premium is equal to its historical average. Mr. Weller suggests that improved monetary management -- better risk shifting, better financial engineering -- have provided a real decline in the risk premium.

"But let's suppose that the true risk premium is around 4% or 4.5%. It's certainly lower than it has been in the past but you still find that the risk premium implied by the market is below that. We find this utterly unrealistic."
As well, says Mr. Weller, the historical P/E ratio for the S&P 500 is about 14.5, but even after the tech bust, it is still above 25. That high P/E will be significant if the market crawls sideways for a number of years with little in the way of profit growth. If that happened you would see a market crash of 50% or more, says Mr. Weller, who suggests Mr. Greenspan needs to gradually unwind the market.

"Instead of a crash you need five dips of 10% spaced over several years. If the Fed were to do that, it could conceivably unwind the effect of the Greenspan put without any significant long-term damage to the economy. The trick of course is to get that right." An act, ironically, that would be the Maestro's finest performance yet.


http://www.nationalpost.com/financi...l?f=/stories/20020214/52304.html


<center>

<HR>

</center>

<ul> ~ Greenspan Put</ul>
<center>

<HR>

</center>