Trading Greenspan

By O'Brian, Terry | Futures (Cedar Falls, IA), January 2000 | Go to article overview

Trading Greenspan


O'Brian, Terry, Futures (Cedar Falls, IA)


Rather than stay on the sidelines during potentially market-shaking news, use Fed Chairman Alan Greenspan's words to profit from market anxiety by jumping in front of the bandwagon.

In October 1999, Alan Greenspan caused a market maelstrom with remarks made before an audience of bank risk managers. Specifically, he issued a warning that the risk/reward ratio may be out of hand and, if that is the case, diversification will fail as a market savior should the bubble burst. Tireless hammering, some traders called it. An evil sport played to the detriment of individuals, others railed, claiming that Greenspan was overstepping his bounds.

Over the years Greenspan's words have become market-moving events in and of themselves. He can shock the market, sending it into a frenzy of activity. In the face of his power, traders should be cautious but not fearful, for the volatility he interjects can make for excellent trades.

Motivational speaker After his October speech, the market fell, and portfolio values with it Forty-eight hours later, Greenspan's comments were all but forgotten, buried in the daily rubble of the marketplace. But while on that night, his audience was specific; his comments contained universal and lasting conundrums: What is the true impact of technology on human nature? Has it changed the face of fear, permanently numbing its impact? If it has not, what happens when risk becomes intolerable?

America has undergone a mind shift. The savings passbook is passe. The real money is made in the markets. Twelve-year-olds have forsaken piggy banks for DRIPs. The economy is strong and will remain so; technology guarantees it. The Great Depressions of the past are no more than historical curiosities, or so goes the conventional wisdom. But the economy -- a huge, amorphous, intangible mass -- shrinks and expands and stagnates as it travels through peaks and valleys of its own making. It has acted this way since the mid-1800s, and though its past paths may be analyzed and synthesized, its future cannot be foreseen.

What was Alan Greenspan thinking as he surveyed the world's varied economies that October evening in 1999? Certainly, he was attempting to look forward, but he had a deep closet of the past to digest and integrate into his thinking. For even as the world turns and toils in crisis after crisis, the Fed must stay levelheaded, ever the stalwart. Greenspan's words that night brought to bear some points we may have forgotten in an economy that somehow seems different this time.

In his speech, he focused on the lowering in equity premiums. Equity premium is the risk/reward ratio -- the trade off between the level of risk and the potential for return. Historically, investors have -- demanded a higher rate of return based on their perception of risk in the asset under consideration. But in recent years, investors have been willing to take on greater risk with less return.

Why? Is it due to increased technology and the ready availability of real-time information? Or, might it be little more than the result of a prolonged business expansion without a significant period of adjustment? Has there been a permanent increase in the learning curve as a result of decades of data, or have investors simply become accustomed to excess returns? These are the questions Greenspan posed.

Pointedly, in the Chairman's words: "The key question is whether the recent decline in equity premiums is permanent or temporary. If the decline is permanent, portfolio risk managers need not spend much time revisiting a history that is unlikely to repeat itself. But if it proves temporary, portfolio risk managers could find that they are underestimating the credit risk of individual loans based on the market value of assets and overestimating the benefits of portfolio diversification."

Greenspan issued a warning: "But while financial intermediation, through its impetus to diversification, can lower the risks of holding claims on real assets, it cannot alter the more deep-seated uncertainties inherent in the human evaluation process. …

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