FSO Editorials

Will We Have 'Fantasia' at the Fed?

by Thomas P. Au, CFA, Author & Market Analyst. May 2, 2006

As I noted in an interview with the Wall St. Transcript last fall, the changing of the Fed chairman has been a traumatic event in my lifetime. Black Monday of 1987 happened two months after Alan Greenspan took office. Paul Volcker brought about interest rates near 20% by initiating a policy of monetary control in 1979. Arthur Burns, in 1970, stepped up to the plate right before the 1971 unpegging of the dollar from the gold standard, and its de facto devaluation. (I wasn't around for the ascension of William McChesney Martin in 1951, but believe even that was eventful.) The one major exception to the rule was the uneventful and largely forgotten 10-month tenure of G. William Miller in 1978-1979, but I expect this transition to represent a more than ten-month appointment, hence the rule, not the exception.

The hallmark of Greenspan's tenure has been crisis management. He led the way for "circuit breaker" rules after the 1987 crash. He also generated a steep yield curve in the early 1990s that allowed banks and other financial institutions to "clean up" their default-ridden balance sheets by making new loans at record spreads. More recently, he provided liquidity (and confidence) to the markets in the late 1990s in anticipation of a Y2K crisis, and mitigated the 2001 recession by cutting the discount rate to 1.0%.

All this took place at the cost of creating "legacy" issues. These include the twin budget and trade deficits, a housing bubble (which replaced the turn of the century stock market bubble) and an indebted (or indentured) consumer living in what Warren Buffett has termed "a sharecropper society." Meanwhile, major developing countries like China and India are experiencing massive growing pains that are being aggravated by the unprecedented injection of global liquidity by the American Fed. Even so, Greenspan's questionable policies have so far been redeemed by masterly execution. My book, A Modern Approach to Graham and Dodd Investing opined, "It may have been [Greenspan's] very success at managing decent sized crises that causes the world to put too much faith in his ability to head off the big one… In short, it was the kind of thing that George H.W. Bush (Senior) might have referred to, in one of his more lucid moments, as "voodoo economics."

This is no time to be sending a rookie "pitcher" to the mound with the bases loaded and none out. (I wish Greenspan had retired some years ago so that his successor would be broken in by now.) Ben Bernanke has Greenspan's educational level and intellect, but not his Washington experience or deft touch. Although Donald Trump is sometimes criticized for his financial management, does anyone seriously believe that the Trump Organization would be better off if he were hit by the proverbial "truck," and one of his thirtyish "apprentices" were placed in charge?

In the Walt Disney movie, Fantasia, the Sorcerer�s Apprentice said the wrong words and opened up the floodgates. I am not at all sure that Greenspan would be able to head off the coming financial storm if he were still in charge. And in my heart of hearts, I do not believe that the Apprentice is up to the job.

In terms of investment implications, I would be looking for an increase in volatility, with the VIX as good a proxy as any. This suggests the use of "straddle" strategies with put and call options, that bet on "extreme" outcomes, and against "intermediate" results. I also find it interesting that gold resumed its rise about the time when Bernanke's appointment was made last fall (the issue was the succession, not the successor), and am therefore an owner of gold stocks such as Newmont Mining.

Disclaimer: Long Newmont Mining

Contact Information

Thomas P. Au, CFA | Author & Market Analyst, R. W. Wentworth | New York City, NY | Email