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Thursday, July 03, 2003

The Greenspan Put

The Greenspan Put

For some reason I missed this one when it was published, but its still highly relevant today:

Call it the Alan Greenspan rally. One brief speech by the Federal Reserve Board chairman warning of the dangers of deflation, and both the stock and bond markets capped a three-month rally with a sharp burst last week. Since March 11, the Standard & Poor's 500 index has risen 23 percent, and the Nasdaq composite index is up 28 percent. Is this a new bull market? Be careful.

A growing number of professional investors and traders are warning that this current rally may have risen too far, too fast. Not only are too many investors suddenly bullish, but a spate of insiders sold large amounts of stock in May. Stock prices remain expensive compared with current earnings, one of the lingering legacies of the bubble three years ago. "I'd say it's a bubble within a bear market,'' says Joe Corona, executive vice president of the Dynamic Hedge fund who is watching for signs of a decline. ``It's a bear with indigestion.'' Some attribute the rally since March to the new tax cut on dividends and capital gains, the hopes for an economic rebound soon and on the expectation that the Fed could lower interest rates again when it meets June 24 and 25.

In his speech last week, Greenspan pointed out the national economy weakened in March and April but believes it showed signs of a ``fairly marked turnaround'' since then. The danger is that a weak economy might add pressure on prices leading to deflation, a widespread decline in price levels. The process of deflation can sap an economy because it feeds on itself. Weak economic demand can lead to declining prices that translates into declining profits, more layoffs and plant closings. And as employees are laid off, that hurts wages and further undercuts demand. To avoid such a spiral, Greenspan told international central bankers last week that the Fed would take out some unspecified ``insurance.'' Most analysts thought he was considering further interest-rate cuts, which immediately drove bond prices up and bond yields down in anticipation.

In trading parlance, this has been called the ``Greenspan put.''

During the 1990s, Greenspan took action to protect the market from some of its worst excesses, such as orchestrating the bailout of failed hedge fund Long Term Capital Management. By protecting the market against its worst declines, he was giving investors the same kind of protection against sudden losses that put options can serve.

An investor buys puts to protect a stock portfolio from losses during a temporary market decline. The option costs a fraction of the price of the stock but can make sizable gains if the price of the stock drops, offsetting some of the loss.

Now, as the danger of deflation rises, Greenspan is concerned a weak economy and stock market could drag each other down.

``The Greenspan put has been issued,'' Corona says. ``Greenspan and the Fed have made it clear that they are going to protect investors.''

With this assurance, investors and speculators have begun to bid up prices. However, some warn that there's too much optimism. One widely watched indicator from the American Association of Investors Intelligence shows 57 percent of the investors are bullish and only 21 percent bears. In March, before the rally began, the sentiment was much different: 39 percent were bullish and 38 percent were bearish.

Another widely watched indicator is the so-called ``fear indicator'' of the Volatility Index of the S&P options, which is now at very low levels of 23, a sign of too much complacency. During a sharp market decline, this figure can shoot up to anywhere from 30 to 50.

But stock prices can keep climbing in spite of such warnings. As economist John Maynard Keynes once warned, the stock market can remain irrational longer than an investor can remain solvent. "You're setting up the conditions for a decline,'' says David Rahn, president of Avalon Capital in Port of Redwood City. "It doesn't mean it's going to happen.'' During the bubble in 2000, investors kept pouring money into the stock market even though it showed signs of becoming overvalued. Today, the Standard & Poor's 500 index is selling for 31 times the earnings per share over the last four quarters of its companies -- exactly the same as the peak of the bubble in March 2000, according to Bloomberg News. This measure's historical average is about 17 and can drop below 10 during major bear markets.

Joe Sunderman, director of trading at Schaeffer's Investment Research, believes enough investors still have cash in money-market funds to keep buying stock. ``As long as people are talking about the bear market, there's money on the sidelines that can move back into the market and move it higher,'' he says. At some point, this will change. Signs of a coming decline would include seeing some leading stocks begin to weaken, and some leading industries, such as semiconductors and brokerage firms, beginning to show slumping prices. George Muzea, president of his consulting firm specializing in insider transactions, says rising insider selling indicates trouble for the coming weeks. He is issuing an advisory to his 60 institutional clients to prepare for a market decline. Among the insider transactions he follows, there were 205 insider sales of stock for every 100 purchases in May. In March, when the current rally began, there were only 77 insider sales per 100 purchases, he says. "There's no question in my mind that we're at a top,'' says Muzea, author of a book on insider selling, ``The Vital Few vs. the Trivial Many.''
Source: SiliconValley.com

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