Don't you miss the Greenspan put?
FOR most of the post-war period, macroeconomic stabilisation policy was an endogenous driver of stockmarket cycles and valuation. If the market fell enough, investors would conclude that fiscal and monetary policy would, eventually, respond, if not to stocks themselves then to the darkening outlook for the economy that a declining market foretold. Conversely, if stocks rose enough, they’d anticipate that the authorities would eventually take their punch bowl away for fear of inflation. Endogenous policy had two important, distinct impacts on stocks. The first was to modulate bull and bear markets. There’s a reason one of the Wall Street’s most enduring adages is “Don’t fight the Fed”: profits and dividends may matter in the long run but in the short run, the overwhelming fundamental driver of stocks was monetary policy. The second impact was on valuation. As bad as things might be, there was a limit to how bad policymakers would permit them to get. As central banks got better at stabilisation policy over the 1980s and 1990s, the equity risk premium fell and price-earnings ratios rose. The Greenspan put was a caustic encapsulation of the belief that the Fed, under Alan Greenspan, its longtime chairman, would always bail stock investors out of their losing positions. That was obviously ludicrous. But it contained an important, and useful, grain of truth. If the Fed could, and would, always act to prevent economic catastrophe, that imparted option value to equity valuation.That’s why the growing belief that policy, today, is helpless is so important for the market. The decline in equity prices in recent weeks seems out of proportion to the economic news, though of course the market may have correctly anticipated that the economic news is about to get much worse. I suspect some of the decline reflects a rise in the equity risk premium as investors take on board the realisation that policy is no longer endogenous.This has actually been going on for some time. Policy in recent years has still produced the usual, cyclical response: witness the powerful rally that followed enactment of the TARP, round one of quantitative easing (QE) and fiscal stimulus in 2008-2009, and then after the Fed teed up QE2 last summer. But markets have subsequently settled at lower highs and lower lows, and this is at least due to the steady leakage of valuation support as investors lower their expectations of what policy can achieve.This helps explain the market’s confused reaction to the Fed’s announcement on Tuesday that it would keep interest rates at zero for two more years. It provoked two, conflicting responses. One was the bullish, pavlovian belief that the Fed had again done whatever was necessary to restore economic growth and profits. In the opposite direction, however, was the realisation that what the Fed proposed was awfully unimpressive. Monetary policy may still have ammunition but it consists of broken pool cues and aluminium bats, not bullets and bazookas (can you tell I’ve spent the week in London?).Many will protest that both monetary and fiscal policy have plenty of options left. America could enact aggressive fiscal expansion financed by new QE. Europe could move decisively towards a stronger fiscal and monetary union that would permit the European Central Bank (or some other European institution) to buy up as much peripheral government debt as necessary to guarantee that sovereign liquidity crises will not lead to solvency crises. Both could raise their inflation targets, making much lower real interest rates possible.All true. But for practical purposes, markets don’t care about what policy can do, they care about what policy will do. What good are such options if there’s no way our political systems will permit them? And the message out of Washington and Europe in the past few weeks is that they will not.There is precedent for this. Valuations last hit lows in the 1970s and 1980s. The despair over policymakers’ inability to root out intractable, debilitating inflation then was qualitatively similar to the despair today over their inability to restore above-trend growth. Even after central banks broke the back of inflation in the early 1980s, investors had to take into account the fact that policymakers henceforth would put inflation first and the economy and profits second in their priorities. The big, secular rise in valuations began when it became clear that inflation had become better anchored, leaving central banks free to focus more attention on economic output.I suspect that the policy paralysis today is worse, though I’d love to be proven wrong. The Greenspan put is not out of the money: it simply no longer exists. If you can’t count on policy to support equity prices, you’re left with book value, cash flow, and dividends. That’s a sobering message. As Buttonwood notes, valuations are still not cheap based on long-term earnings trends. If policy is no longer endogenous, equity risk premia have to rise. And so far, they may not have risen enough.