Friday, February 20, 2009

Greenspan Was Right in 1996

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.

Alan Greenspan, Dec. 5, 1996

On the day Alan Greenspan spoke those now famous words warning that stock prices might be too high, the Dow Jones Industrial Average closed at 6437.10. Yesterday, more than 12 years later, the Dow closed 16% higher at 7465.95, which comes out to about 1.2% on an annualized basis. Of course, the Dow peaked at more than 14,000 before falling back to current levels. If anything, this should cause investors to question the wisdom of long-term, buy-and-hold investing. That approach is akin to simply sticking your head in the sand and ignoring signs of trouble. A strategy of active asset allocation, i.e., taking money off the table after rallies and buying more after selloffs, produces much better results over the long term.