The FRB: Jeers, Tears and Cheers

Over 60 years, I’ve hated many FRB chairmen. True, a couple saved the country from self imposed stupidity. I’m thinking of Paul Volcker and Ben Bernanke, who decades apart, proved fearless operators. They saved our system from certain ruin, what you encounter in banana republics, cycle after cycle.

50 years ago, I cursed McChesney Martin known for his quip “taking away the punch bowl”Alan Greenspan was to be ignored for dozens of his “interventions” in the money market. I do credit Ben Bernanke for saving the economy in 2009 when our banks were hopelessly mired in their stupidity, funding mortgages with mythical asset security. Bernanke was assisted by Bob Rubin, then our Secretary of the Treasury. I knew Bob, back in the sixties, then head of arbitrage, reporting to Gus Levy, Goldman’s demanding chairman.

On Wall Street, level-headedness is a trait worth your weight in gold. To this day, I believe our major banks, like Citibank, even JP, Morgan Chase, periodically put themselves in deep financial trouble, making leveraged loans that turn sour during economic downturns. Currently, some banks sell close to the market’s earnings multiplier of 18 times earnings. I’m closer to a 10 times multiplier and at book value, not 1.5 times to 2 times book.

What I remember about Alan Greenspan was his bias to wax optimistic, too goody 2 shoes. After all, late nineties, the Street's projection on earnings was a sham when you adjusted for tons of options issuance, many outrageous earnings write-offs, and special charges.

Investors with a sense of history know that the rate of return for equities can be negative, even for a 10-year period. The historic return comes in at 6.1% with an equity premium of 2.4% and an inflation adjusted rate of return for 10-year Treasuries at 3.7%. Real returns are systemically lower than earnings yields throughout financial history.

The financial meltdown of 2008- 09 set the S&P 500 Index back to 700. Then we saw the right side of the W, taking out the old 2000 high late in 2013. Net, net, the market acted like a roller coaster for over 14 years. If you seriously violated conventional valuation discipline, chances are you got washed out with little wherewithal for a come back.

When Alan Greenspan dropped the Fed Funds rate 50 basis points early in 2001, NASDAQ rallied almost 15% overnight while drug stocks declined sharply (no leverage in earnings). Everyone managing money got busy discounting the coming economic expansion.

Alan was great stepping in with a shot of liquidity morning after Black Monday. Still, I have reservations about whether Greenspan read the 90s as well as he read mid-to-late eighties. For years, he underestimated tremendous gains in productivity because of the unprecedented capital goods spending boom. Then he completely missed the fiscal drag during the Clinton years.

Republicans controlled the Congress, so few fiscal spending bills made it through except for defense initiatives. The Fed, probably contributed to the rate of inflation by raising interest rates unnecessarily. There were approximately 50 changes to the discount rate between Greenspan’s, ascending in 1987 and his retirement in 2006. Meanwhile, the public kept spending, reducing its savings rate to next to zero. Nobody anticipated such a variable.

This chart on capacity utilization shows that for much of Greenspan's reign, utilization stayed above 80% for a healthy span of years. “When in the dark, you make your way by probability.”

Capacity Utilization

Total Industry

I like Alan’s semi opaque, Fed speak mode: “The relationships among the new economic variables are imperfectly understood, and as a consequence economic forecasting is an uncertain endeavor. We should not overreact to every bit of new information, because frequently observations are subject to considerable transitory noise.”

For me, Alan was drowning in self made pomposity by mid 2000. Washington’s adulation had gotten to him. Too many bumps in the Fed Funds rate. Back in 2000, the market traded between 1450-1550, less than half where we stand presently. The S&P 500 didn’t even reach 1650 for years.

We should thank Paul Volcker for forcing the last big recession on the country in 1982. It purged inflationary expectations and made Greenspan’s job a snap. Volcker gets credit for starting our second Gilded Age, summer of 1982. When the S&P 500 index trickled down at 100, Yes! 100! Peaking at 1400 eighteen years later.

Just as Greenspan was a subconscious captive of Wall Street when he was cutting the Fed Funds rate bi-monthly, I sense our current FRB chairman is too conciliatory when he hints, his board could taper down Fed Funds bumps of 75 basis points, quarterly, to 50 basis points by year end. As yet, the Street seems tentative on discounting any change that’s more than cosmetic. We’ll see.

When Jerry Goodman, (Adam Smith), my old old buddy, now gone, was interviewing Greenspan decades ago. He asked Alan if what he did was “fun.” Greenspan probably never had to field such a question and he was nonplussed. Jerry, forever devilish and insouciant with bigwigs, had blindsided the Oracle. Alan responded “Well, not exactly,” and moved on to more weighty pronouncements. Alas! Central bankers don't talk like stand-up comics, who themselves can be full of wisdom. Central bankers sound ever more mealy mouthed particularly in Japan and Euroland.

My problem with Jerome Powell is subconsciously he wants to please the Street which is the last thing a Fed chairman should want to do. Why else would he say tapering of the Fed’s money market bumps of 75 basis points could ease to 50 points near term under certain conditions.

Paul Volcker, is my standup man and hero. I remember him pushing interest rates up to 15% on FNMA notes. Chrysler was bailed out by the U.S. Treasury. They figured out it was cheaper to do so then pay out unemployment insurance. Same goes for General Motors in the 2008-09 financial meltdown. The S&P 500 was valued at 10 times depressed earnings. When I bought a bunch of FNMA notes, my partners tried hard to throw me out the 42nd floor window of our offices in the General Motors Building.

If I remember correctly, Volcker lived in an efficiency apartment near the capital, walking distance to his offices. Everyone missed the call on the 1982 recession. It was the call of the Group of Seven’s major economic monetaries jacking up interest rates.

Today, it’s hard for me not to believe the world is combustible. Just read page one of the WSJ and New York Times. Valuation close to 20 times earnings should be under 15 times, even lower.

My entry into two-year Treasury notes is turning out to be sheer stupidity even with the paper yielding at a premium to 10-year notes. A rare disparity.

It’s the old story. Implementing what looks cosmetic on the surface can lose you lots of money. The Great Humbler strikes again and again. Earnings seem iffy to me with recession, an even money bet. Any action or inaction by our Fed is more likely to be cosmetic, not earthshaking and timely.

Changes in interest rates normally are large and can be long lived. Cycle over cycle interest rates do increase in volatility. The Blue Chip Forecast by economists has missed its numbers more often than not by over 1 percentage point on average of 3%, a 33% miss.

Even the International Monetary Fund in its forecasts for the world, discovered their forecasting errors were so great as to make them practically useless for suggesting policy initiatives.