Alan Greenspan, Market Timer?

Floyd Norris's piece in the New York Times "A 10-Year Stretch That's Worse Than It Looks" is well worth reading.

Click to read article

According to Norris, the 10-year stretch ended January 31, 2009 represents the worst 10-year return (in real terms, including dividends) since the S&P 500 index was created. The compound annual loss in purchasing power was 5.1%.

Further says Norris, "Taking inflation and dividends into account, an investor who put money into the market any time after the end of 1996, and held on, now has less value than when he or she started."

Here Norris misses the opportunity to trot out Alan Greenspan's infamous "irrational exuberance" quote. Over the years, I have asked many sophisticated investors and financial professionals if they remember when Greenspan made the comment. Most give answers between 1998 and 2000, corresponding to the Nasdaq bubble.

In actuality, Greenspan made the comment on December 5, 1996. Closing prices of the major US indices that day (and on Jan 30) are shown here.

It's worth remembering Greenspan's quote more fully. The Fed chairman was addressing the American Enterprise Institute for Public Policy Research on the topic "The Challenge of Central Banking in a Democratic Society." In a wide-ranging speech that briefly covers the history of the central bank, Greenspan raises the issue whether the Fed's goal of price stability should include not just the prices of those goods and services that make up the inflation indices, but of financial assets as well.

"But where do we draw the line on what prices matter? Certainly prices of goods and services now being produced--our basic measure of inflation--matter. But what about futures prices or more importantly prices of claims on future goods and services, like equities, real estate, or other earning assets? Are stability of these prices essential to the stability of the economy?"

"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?"

How do we know when? When the Fed chairman starts talking -- however obliquely -- about overheated equity markets, that's when.

Ironically, Greenspan finishes up with the following thoughts:

"Along with our other central bank colleagues, we are always looking for ways to reduce the risks that the failure of a single institution will ricochet around the world, shutting down much of the world payments system, and significantly undermining the world's economies. Accordingly, we are endeavoring to get as close to a real time transaction, clearing, and settlement system as possible. This would sharply reduce financial float and the risk of breakdown."

Oops.

For the full text of Greenspan's speech, click here.