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You Won, Alan; and That's the Problem
Alan Greenspan has had a lot to say in the last couple of weeks. His "irrational exuberance" crack about the stock market got the press, but the most important thing he said was this single sentence: "Risk premiums for advancing funds to businesses in virtually all financial markets have declined to near-record lows."
All markets have lost touch with risk? Best think this one over.
Risk appears in markets in several guises. The foremost is credit: if I invest, will I get my money back?
Example. There are two distinct markets for long term business borrowing: "investment grade" bonds, and "junk." Bonds rated AAA down to BBB have very low risk of default, and pay equally low rates, usually less than a percent above Treasury rates. In 1991, un- or low-rated junk traded about seven percent over Treasury rates. Today, that risk premium is barely three percent. General Motors versus some outfit that hasn't completed its first year in business, only two points apart.
Time is another aspect of risk. No specific event; just the passage of time; time for accidents, bad management, bad politics, warÉ.
Example. This last week, the Treasury paid 5.70% to borrow money for one year, and 6.82% for thirty years. An extra 29 years of risk, and you earn a premium of 1.12%. Reasonable? Not by any historical measure.
Yet another question of risk: am I paying too much for an estimated future return?
Example. Anybody who owns, ever owned, or thought of owning stocks knows that price-earnings ratios are at all time highs. High prices are okay if future earnings are secure. Since when did all corporate earnings become secure?
Another facet on the fun-house mirror of risk: change. Investors, borrowersÉ everyone evaluates the future based on the remembered past. A volatile recent past makes everybody nervous, and markets will charge and pay big premiums for the perception of continuing risk. A calm nearby past, and everyone expects the future to be placid.
Example. Interest rates have fallen in twelve of the last fifteen years. Especially in the mortgage markets, borrowers assume that the future will be just as pleasant. It's downright trendy for home buyers to pursue adjustable (risky) and balloon (foolhardy) loans. I hate to disappoint, but interest rates will not fall in twelve of the next fifteen years. The rise to a peak in 1982 was a unique event, and so was the following downside.
How did we lose our sense of risk in so many markets at once?
Mr. Greenspan, the chief alarmist, is the guilty party.
Years ago, Alan Greenspan defined success in his battle against inflation: "inflation removed as a factor in economic decisions." Not zero; just no longer an issue.
Alan, baby; you won!
We're not worried anymore. In the 15 years preceding Mr. Greenspan's appointment, 1972-1987, the average annual inflation rate was 10.5%. In the ten years of his chairmanship? A little under 3.5%. No single year has come in as "high" as 4% since the spike in oil prices during the 1990 Gulf War.
If you forget about inflation, it's perfectly sensible to invest in bonds bearing low interest rates, or borrow at adjustable ones. A balloon mortgage is a great idea: you can always refinance at the same cost, or lower. Nor need you fear that the Fed will hurt the stock market, or the companies that issued the bonds in your Strategic Fortress High Income Fund. Sure, there will be a recession some day, but then the Fed will lower interest rates, not raise them.
All true, without inflation.
It's awkward for the winner of the great victory to warn that triumph over inflation is always temporary, but that's what he's doing.
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