Mr. Greenspan had interesting things to say today and we think history will view his speech as important for taking a much more direct aim at the troubling economic imbalances wrought by the stock market bubble. Clearly, he left little doubt today that the Fed is taking a keen interest in rising asset markets. Mr. Greenspan began his speech, "I should like as a backdrop to this conference on the challenges confronting monetary policy to focus on certain aspects of one of the issues that will be more broadly discussed later this morning: asset pricing and macroeconomic performance. As the value of assets and liabilities have risen relative to income, we have been confronted with the potential for our economies to exhibit larger and perhaps more abrupt responses to changes in factors affecting the balance sheets of households and businesses." Here we will focus on Greenspans recognition that rising "liabilities" are an issue. In a bubble economy, such as ours today, it is the huge expansion of debt that comes back to haunt the system with the inevitable collapse in asset prices. Greenspan is clearly becoming increasingly concerned with economic distortions emanating from wealth effects. Interestingly, Greenspan also commented on stock options and the role they have played in overstating corporate profits. We have, for some time, believed that stock options have been one of many factors that have overstated profits, but we also believe that options have played a large and growing general economic role, producing wealth effect distortions and a bubble economy.

Taking an excerpt from Gretchen Morgensons August 15th New York Times Market Watch article, Rumbling of an Avalanche, "Companies of all kinds have issued oceans of options in recent years...How big is the overhang? Bob Gabele, director of insider research at First Call/Thomson Financial, calculated all the option grants made by companies in the NASDAQ 100 stock index from 1994 to 1998. A staggering 4 billion shares were granted, worth $220 billion at recent prices. That amounts to roughly 9 percent of the market value of the entire NASDAQ100 index." Ms. Morgenson then quoted Baruch Lev, professor of accounting and finance at New York University, "This is an avalanche-in-waiting. And this avalanche may fall at the worst time of all."

Keep in mind, this $220 billion is just from the 100 largest NASDAQ stocks and for only a four-year period. According to estimates by Joe Carson at Deutsche Bank, at June 30th, the market value of stock options issued by S&P500 companies totaled $543 billion. And with companies throughout the country adopting stock options as an important part of compensation packages, it is not unreasonable to estimate that as much as $1 trillion of stock options now exist. This is a big deal and the related wealth effect is very dangerous to the stability of our economy and financial system.

Clearly, there is a mountain of "employee" stock that will pose an "overhang" problem on the marketplace, particularly after the stock market bubble is pierced and there is a mad scramble towards wealth protection. Today, however, there is another issue that we think is critically important but garners little attention. Basically, our overheated financial sector is virtually running out of control in "monetizing" asset inflation, and this is covertly playing a most important role in perpetuating our financial and economic bubble. And while this has been going on for some time, we believe it is much more prevalent today and the degree of this monetization is at the heart of very dangerous imbalances that continue to weaken the underpinnings of our financial system and economy.

Recently, an advertisement caught our eye from Investors Business Daily: "90% Protection  The 90% Stock Loan." The ad comes from First Security Capital, out of San Francisco. Now, we have no idea if they are doing a lot of business, but we would be shocked if employees, particularly from Silicon Valley, are not lined up in droves to take advantage of this deal. Here is what they offer: "First Security Capitals 90% Stock Loan  the proprietary financial instrument that provides liquidity without triggering a taxable event, protection from a market downturn, and unlimited upside potential."

And continuing from their website: "With capital gains in your portfolio or vested options, you would be subject to capital gains taxes should you decide to sell  taxes that would be especially significant if you have shares with a low relative cost basis, or have employee stock options with a low relative exercise price. Loans, however, are not taxable events. So in many cases you could actually net more cash by borrowing 90% of the current value of your stocks with our 90% Stock Loan than if you were to sell. And because you still own your stocks, you retain the ability to realize future growth in the value of your portfolio. The loan is also non-recourse, so you have no personal liability for your loan, and your maximum downside is capped at 10% for your entire loan term. Ultimately the 90% Stock Loan can help you net more cash, get long-term downside protection, and keep your stocks. "

"Diversify into real estate or other ventures by leveraging your stock portfolio  without the risk of a margin call if your stock declines in value. You can access standard margin loans when it comes to leveraging your stock portfolio, but these leave you exposed to downside risk if your holdings drop in value. Our 90% Stock Loan is non-callable and it has no margin maintenance requirements, so it enables you to leverage 90% of the value of your stock portfolio without the risk of a cash squeeze from a margin call. And unlike margin loans, with the 90% Stock Loan you are not required to make any interest payments until the end of your loan term. Than means you get 90% of the current value of your stock portfolio in cash and you have long-term downside protection  without negative cash flow. So you can leverage your stock portfolio and diversify into real estate and other ventures without worrying about making monthly payments or meeting margin calls."

"With the 90% Stock Loan you receive 90% of the current value of your portfolio in cash, and still keep your stocks. Even if your stocks go down significantly in value over the course of your loan term, you have no obligation to repay either the original loan or the accrued interest at maturity  yet you continue to realize future growth in the value of your portfolio if it keeps going up."

First Security Capital has other products as well, including the "Option Conversion Loan", the "MicroCap Loan", the "ESOP Qualified Asset Loan," and the "Foreign Stock Loan." Our favorite, however, has to be the "Restricted Stock Loan" that allows individuals to "monetize equity in securities that are subject to restrictions, lock-ups, or legends with various Restricted Stock Loan programs."

Interestingly, the Internet News Bureau ran a story last October introducing First Security Capitals new product: "Now a new revolutionary financial tool gives investors the power to manage their risk exposure and liquidity like the elite."

This statement is certainly true, as Wall Street for some time has provided similar products to corporate management, as well as wealthy clients. Security firms have aggressively offered their corporate clients loans against stocks and options. Not surprisingly, this type of loan is very attractive as it provides liquidity without even having to sell a share of stock; no taxable events and no insider sales transactions. Derivative desks have been active players as well, providing "insurance products" that have allowed stock and/or option holders to lock in gains from this amazing bull market. And, importantly, derivative "insurance" has likewise allowed individuals to lock in gains without having to sell. What a deal!

Admittedly, this could not appear any more wonderful - a virtual financial miracle with so many being able to generate huge amounts of cash from appreciating financial assets without having to find new buyers. No need to find cash buyers if the financial system can just keep creating more credit. Actually, however, we see this as all part of one of the most critical issues today facing our financial system and economy. And we also think this issue may be, in fact, on Greenspans mind in Jackson Hole, Wyoming. While many credit our "new" incredibly productive technology-driven economy for our nations current prosperity, we tend to see things differently. Instead of computers and the Internet being behind our boom, we think the overriding responsibility lies directly within the financial system. Its called a credit bubble, a resulting asset bubble, and a sophisticated "new era" financial system with an astounding proclivity toward excess. As such, we actually see First Security Capital as a fantastic example of such excesses and exactly the type of situation that may now be agitating Greenspan.

Whether it is home equity loans, or loans using collateral such as stocks, options, or even hotels, office buildings, or golf courses, our system has developed a dangerous propensity for monetizing asset inflation. Indeed, the more asset prices have risen, the more keenly our financial system has focused its lending to the asset markets. And the greater the focus on asset lending, the greater the inflationary bias and the greater becomes the asset bubble. With rising asset prices, more can be borrowed and spent throughout the economy, which only encourages greater excess and even higher asset prices. Over time, as more and more of the financial system and economy are geared towards asset inflation and wealth-effect-generated consumption, the whole quagmire becomes one big bubble economy.

Today, with our countrys housing market on fire and the stock market again with huge gains, more homeowners are free to borrow against inflated home prices and more employees can proceed to First Security Capital and monetize their stocks and options. Sure, this works great today, perpetuating the boom. Employees out in Silicon Valley, and throughout the country for that matter, can borrow against the millions of gains in stocks and options and not fret when paying inflated prices for homes. And because these inflated prices immediately become the imputed value for homes throughout the area, all homeowners have greater perceived home equity that they can withdraw to spend or play the stock market. And, again, no one even has to sell a share of stock for all this spending power with our financial sector so willing to lend against inflating assets. For our financial system and economy, this has and continues to appear like magic as liquidity flows throughout, fueling what appears to be the greatest and most sustainable period of prosperity man has ever experienced.

There are, however, some big problems here. For one, it is built almost completely on ever-greater amounts of debt; it is one massive credit bubble. While the "90% Protection" loan is a great deal for those wishing to convert stocks to cash, the cash comes from additional credit created within the financial system, just as the cash from a home equity loan is but additional credit for the system. Come the inevitable day of declining asset prices, our financial system and economy will be impaired with this mountain of debt backed by insufficient collateral values. Moreover, the "90 Protection" loan is really nothing more than a derivative transaction and, in fact, the company is headed by a derivatives specialist.

The reason the borrower maintains full upside exposure to stock gains is that the shares are not sold. Instead, First Security Capital believes it can "hedge" its exposure if stock prices decline and, hence, will be able to repay the companys debt that today provides the cash for stock and option loans. This, like most derivatives that have come to so dominate our financial system, works well during bull markets. We, however, see these derivatives much a ticking time bomb. One of these days, we will have a bear market and First Security Capital and other writers of derivative insurance protection will be forced to sell securities to hedge their exposure. And if enough buyers do not come forward willing to part with their cash in the midst of a sinking market to take the other side of these trades, markets will suffer a liquidity crisis. And we, unfortunately, see no way around such an occurrence as our over-zealous financial system has created truly unfathomable "perceived wealth" throughout our economy that is supported mainly by overvalued securities and unprecedented credit excesses. This is truly a house of cards that will be exposed one of these days when investors move to convert some of this "perceived wealth" into cash. This could come from investors moving to raise cash, or it could come from the derivative players moving to hedge their exposure to lower stock prices. Likely, it will come from both areas. We are not, however, sure who will step up with the cash necessary to accommodate those wishing to sell. But, then again, that is why wild speculations do not end happily. In this regard, this week certainly ended with signs that this most recent speculative spell might be dissipating. All eyes next week on stocks, the credit markets and the dollar. It is certain to be another wild week.

David Tice

www.prudentbear.com

-- Andy (2000EOD@prodigy.net), August 29, 1999

Answers

THE 401(k) TIMEBOMB

We are deeply indebted to the folks at the Leuthold Group for pointing out to us a survey that appeared in the late July edition of Pension and Investments Age. For those unfamiliar, P&I is sort of an institutional trade mag for the defined benefit/contribution/401(k) plan sponsor, investment management and custodial crowd. (Believe us, it's a big crowd.) The article contains the results of a Fidelity sponsored survey of 401(k) participants. To us, the results of the survey are enough to make the average "thinking" investor move directly to cash. The following table is a capsulated summary of the results. Take a very deep breath before going any further: *Avg. Avg.401k Equity as% %of Participants Annl. contributions* *Age Balance of Total borrowing from as % of* *Assets plan plan* *30_$15,000_ 89 %_19 %_22 %* *45_$54,000_ 83 %_35 %_40 %* *57_$162,000_85 %_32 %_50 %* To us, these responses are nothing short of shocking. They clearly exemplify a "Main Street" 401(k) participant who has taken the current bullish Wall Street bait hook, line and sinker. We hate to sound so melodramatic, but these numbers suggest to us that an absolute panic lies ahead at some point. Of course, talk to any "new age" 401(k) equity investor and they will proclaim strongly that they are in it for the long term...(at least for now).

The Pre-Retirees

As you would imagine, the largest absolute dollar balances reside in the earliest to retirement baby-boomer accounts. Not only is this crowd most driven to build the assets with the working life they have remaining, but also should have had the largest balances at the outset of the rapid bubble growth period some three or four year back and should have been the largest dollar beneficiaries of the equity mania. Despite all of the claims that the currently negative savings rate is misleading because the public is saving in it's 401(k)'s, contributions by this group stand at only 50% of the maximum allowable. The real shocker is that 32% have borrowed from their plans. Now what was that about the strong saving that is happening by the boomers again? Run that by us just one more time.

The clincher for us is that the pre-retirees have 85% of their assets invested in equities. Just imagine what a normal 25-35% bear market would do to these accounts. A normal bear market could easily turn 30% of total asset value into dust. God forbid the market go down and stay down. We have argued for some time that we do not believe the real equity selling will begin until the market is already down 25-35%. If for some strange reason we are correct, we could easily have a down 50%er at some point. Clearly with the most to lose, we have to believe the pre-retiree crowd would simply panic for the door. Would they have any other choice so close to retirement? What makes matters worse is that the very age group with the most to lose also has the most stock to potentially sell. The balance of the average 30 year old is simply peanuts compared to their nearly retired brethren. We have to believe that the largest risk to this wonderful bull are the pre-retirement baby boomer set. Lastly, although we make zero predictions, any lightening of the old equity exposure prior to Y2K would most like come from the near retirement bunch.

The Early and Mid-Lifers

Certainly those in the 20-45 age bracket do have and can afford to adopt a longer term investment horizon. Unfortunately, we strongly believe that this bull market, coupled with the objective media coverage coming from those such as the CNBC "gang", have bred expectations that are simply not realistic. Are the early and mid-lifers prepared for an extended sideways market? Would they ride out a down cyclical bear without emotional reaction? Would they increase contributions to their 401(k)'s to buy more at lower prices? Human nature is tough to gauge. All we can divine is that history has taught us that human nature really never changes. Greed, fear, and panic are indelible components of the human DNA chain. Maybe we are in a new era where all investors fully realize that toughing it out for the long term is the proper course of action. Or maybe not.

Some final comments. Clearly these numbers throw a bit of cold water on the "American's are saving in their 401(k)'s" commentary so blithely spewed forth by Wall Street's best "salesmen/strategists". The level of participants in the 40-60 year old age bracket borrowing from their plans is quite disturbing. To make matters worse, this borrowing is happening in the "best economy in generations". Just what do you think will happen in a cyclical economic downturn? Americans are clearly not maximizing the savings function of the 401(k) vehicle. The best of the annual contribution statistics can't even crack the 50% of maximum allowable number. Just what does this say about the stock market "savings boom"? Lastly, with equity exposure for the entire surveyed group in the mid-80% range, there certainly isn't a lot of existing money left to be allocated to equities as an asset allocation choice in 401(k)'s. As we've remarked too many times in the past, "just who is left to buy?". Since the level of real personal savings in the economy is presently subzero, these 401(k) assets will be critical in any individual's retirement plans. We guarantee that given these statistics of the Fidelity survey, emotions will dictate decision making at some point in time. In fact, we're quite surprised that Fidelity would want these numbers made public. To us, this isn't exactly a strong mutual fund marketing piece. Quite the opposite. http://www.contraryinvestor.com/mo081999.htm *"The fate of the world economy is now totally dependent on the growth of the U.S. economy, which is dependent on the stock market, whose growth is dependent on about 50 stocks, half of which have never reported any earnings..." Former Fed Chairman Paul Volcker, Friday, May 21, 1999*

-- drken (drken@bubble.gone), August 29, 1999.

Andy

There is a thread below about the speach. This makes the Naval Assessment look like a middle of the road document. Great article find.

 Greenspan's Jackson Hole speech (Mitchell Barnes,

Greenspan is YELLING at folks with his speach. When this guy pauses people notice, now he is in "panic" with this kind of speach. And it hits the common folk. Land prices and stock devaluation. But some of his speach was more insidious. This diserves alot more attention.

-- Brian (imager@home.com), August 29, 1999.

And it's getting it on other fora I'm reading - you're quite correct Brian. But is anyone listening?

-- Andy (2000EOD@prodigy.net), August 29, 1999.

Remarks by Chairman Alan Greenspan New challenges for monetary policy

Before a symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming August 27, 1999

I should like as a backdrop to this conference on the challenges confronting monetary policy to focus on certain aspects of one of the issues that will be more broadly discussed later this morning: asset pricing and macroeconomic performance.

As the value of assets and liabilities have risen relative to income, we have been confronted with the potential for our economies to exhibit larger and perhaps more abrupt responses to changes in factors affecting the balance sheets of households and businesses. As a result, our analytic tools are going to have to increasingly focus on changes in asset values and resulting balance sheet variations if we are to understand these important economic forces. Central bankers, in particular, are going to have to be able to ascertain how changes in the balance sheets of economic actors influence real economic activity and, hence, affect appropriate macroeconomic policies.

At root, all asset values rest on perceptions of the future. A motor vehicle assembly plant is a pile of junk if no participants in a market economy perceive it capable of turning out cars and trucks of use to consumers and profit to producers. Likewise, the scrap value at the end of the plant's service life will be positive only if it is convertible into usable products.

The value ascribed to any asset is a discounted value of future expected returns, even if no market participant consciously makes that calculation. In principle, forward discounting lies behind the valuation of all assets, from an apple that is about to be consumed to a hydroelectric plant with a hundred-year life expectancy.

On such judgments of value rest much of our economic system. Doubtless, valuations are shaped in part, perhaps in large part, by the economic process itself. But history suggests that they also reflect waves of optimism and pessimism that can be touched off by seemingly small exogenous events.

This morning, I plan to address some of the problems that arise in evaluating the prices of equities. I should like to first focus on some significant difficulties of profit accounting that impede judgments about prospective earnings. In particular, there are some difficulties that have become more severe as a consequence of the recent acceleration of technologies, which, in turn, are markedly altering patterns of economic organization and production. And then I will discuss a different set of forces that mold the development of discount factors which, together with earnings projections, produce estimates of market value.

First, the rapid shift in the composition of gross domestic product toward idea-based value added is muddying our measures of current earnings and, hence, our projections of future earnings.

The key definitional question that must be confronted is, What is a capital outlay? Conversely, What is an expense that, by definition, is consumed in the process of production and deemed an intermediate product? This issue is most immediately evident in accounting for software outlays, but it is rapidly expanding to a much broader range of activities.

Software that is embedded in capital equipment, and some that is stand-alone, is currently being capitalized and consequently amortized against current and future earnings. But a substantial portion of software spending is expensed, even though the equity prices of the purchasing companies are clearly valuing the software outlays as contributing to earnings over their useful economic lives-- the relevant criterion for capitalizing an asset.

There has always been a fuzzy dividing line between what is expensed and what is capitalized. This has historically bedeviled the accounting for research and development, for example. But the major technological advances of recent years have exposed a wide swath of rapidly growing outlays that, arguably, should be capitalized so that the returns they produce would be more accurately reflected as earnings over time. Indeed, there is even an argument for capitalizing new ideas, such as different ways of organizing production, that enhance the value of a firm without any associated outlays. Some analysts judge the size of undercapitalized outlays as quite large.1

The important point, however, is that decisions about which items to expense will have important consequences for reported earnings. In general, if the trend of expensed items that should be capitalized is rising faster than reported earnings, switching to capitalizing these items will almost always accelerate the growth in earnings. The reverse, of course, is also true.

But the newer technologies, and the productivity and bull stock market they have fostered, are also accentuating some accounting difficulties that tend to bias up reported earnings. One is the apparent overestimate of earnings that occurs as a result of the distortion in the accounting for stock options. The combination of not charging their fair value against income, and the practice of periodically repricing those options that fall significantly out of the money2, serves to understate ongoing labor compensation charges against corporate earnings. This distortion, all else equal, has overstated growth of reported profits according to Fed staff calculations by one to two percentage points annually during the past five years. Similarly, the rise in stock prices, which reduces corporate contributions to pension funds is also augmenting reported profits. These upward adjustments in reported earnings, of course, are a consequence of rising stock prices and, hence, may not be of the same dimension in the future.

Nonetheless, it is reasonable to surmise that undercapitalized expenses have been rising sufficiently faster than reported earnings to have more than offset the factors that have temporarily augmented reported earnings. It does not seem likely, however, even should all of the appropriate accounting adjustments to earnings be made, that such adjustments can be the central explanation of the extraordinary increase in stock prices over the past five years.

However we calculate profits and capital, shifts in the stock market value of firms will doubtless continue to remain important influences on our economies. It is thus incumbent on us to improve our understanding of the process by which projections of future earnings are translated into asset market value.

Even our most sophisticated analytic techniques have difficulty dealing with the interactions among time preference, risk aversion, and uncertainty and with the implications of these interactions for the risk premiums that are embedded in asset prices. It is our failure to anticipate changes in this discounting process that much of our inability to accurately forecast economic events lies. For example, the dramatic changes in information technology that have enabled businesses to embrace the techniques of just-in-time inventory management appear to have reduced that part of the business cycle that is attributable to inventory fluctuations and, accordingly, may well have been a factor in the apparent decline in equity premiums that has characterized the latter part of the 1990s. Whether the decline in these premiums themselves may foster activities that could result in wider business cycles, as some maintain, is an open question.

As model builders know, all economic channels of influence are not of equal power to engender growth or contraction. Of crucial importance, and still most elusive, is arguably the behavior of asset markets. More broadly, there is an increasing need to integrate into our macro models more complete descriptions of the responses of households and businesses to risk--behaviors that are generally modeled separately under the rubric of portfolio risk management.

The translation of value judgments into market prices is, of course, rooted in how people discount uncertain future outcomes. An individual's degree of risk aversion may vary through time and possibly be subject to herd instincts. Nonetheless, certain stable magnitudes are inferable from the process of discounting of future claims and values.

One of the most enduring is that interest rates, as far back as we can measure, appear trendless, despite vast changes in technology, life expectancy, and economic organization. British long-term government interest rates, for example, mostly ranged between three percent and six percent from the early eighteenth century to the early twentieth century, and are around five percent today. Indeed, scattered evidence dating back to ancient Rome and before reflects the same order of interest rate magnitude, not a one percent interest rate nor 200 percent.

This suggests that the rate of time preference underlying interest rates, like so many other aspects of human nature, has not materially changed over the generations. But while time preference may appear to be relatively stable over history, perceptions of risk and uncertainty, which couple with time preference to create discount factors, obviously vary widely, as does liquidity preference, itself a function of uncertainty.

The impact of increasing uncertainty and risk aversion was no more evident than in the crisis that gripped financial markets last autumn, following the Russian default.

That episode of investor fright has largely dissipated. But left unanswered is the question of why such episodes erupt in the first place.

It has become evident time and again that when events are unexpected, more complex, and move more rapidly than is the norm, human beings become less able to cope. The failure to be able to comprehend external events almost invariably induces fear and, hence, disengagement from an activity, whether it be entering a dark room or taking positions in markets. And attempts to disengage from markets that are net long--the most general case--means bids are hit and prices fall.

Modern quantitative approaches to risk measurement and risk management take as their starting point historical experience with market price fluctuations, which is statistically summarized in probability distributions. We live in what is, for the most part, a stable economic system, where market imbalances that produce unusual outcomes almost always give rise to continuous and inevitable moves back toward longer-run equilibrium. However, the violence of the responses to what seemed to be relatively mild imbalances in Southeast Asia in 1997 and throughout the global economy in August and September of 1998 has illustrated yet again that the adjustments in asset markets can be discontinuous, especially when investors hold highly leveraged positions and when views about long-term equilibria are not firmly held.

Enough investors usually adopt strategies that take account of longer- run tendencies to foster the propensity for convergence toward equilibrium. But from time to time, this process has broken down as investors suffer an abrupt collapse of comprehension of, and confidence in, future economic events. It is almost as though, like a dam under mounting water pressure, confidence appears normal until the moment it is breached.

Risk aversion in such an instance rises dramatically, and deliberate trading strategies are replaced by rising fear-induced disengagement. Yield spreads on relatively risky assets widen dramatically. In the more extreme manifestation, the inability to differentiate among degrees of risk drives trading strategies to ever-more-liquid instruments so investors can immediately reverse decisions at minimum cost should that be required. As a consequence, even among riskless assets, such as U.S. Treasury securities, liquidity premiums rise sharply as investors seek the heavily traded "on-the-run" issues--a behavior that was so evident last fall.

History tells us that sharp reversals in confidence happen abruptly, most often with little advance notice. These reversals can be self- reinforcing processes that can compress sizable adjustments into a very short time period. Panic market reactions are characterized by dramatic shifts in behavior to minimize short-term losses. Claims on far-distant future values are discounted to insignificance. What is so intriguing is that this type of behavior has characterized human interaction with little appreciable difference over the generations. Whether Dutch tulip bulbs or Russian equities, the market price patterns remain much the same.

We can readily describe this process, but, to date, economists have been unable to anticipate sharp reversals in confidence. Collapsing confidence is generally described as a bursting bubble, an event incontrovertibly evident only in retrospect. To anticipate a bubble about to burst requires the forecast of a plunge in the prices of assets previously set by the judgments of millions of investors, many of whom are highly knowledgeable about the prospects for the specific companies that make up our broad stock price indexes.

If episodic recurrences of ruptured confidence are integral to the way our economy and our financial markets work now and in the future, it has significant implications for risk management and, by implication, macroeconomic modeling and monetary policy.

Probability distributions that are estimated largely, or exclusively, over cycles excluding periods of panic will underestimate the probability of extreme price movements because they fail to capture a secondary peak at the extreme negative tail that reflects the probability of occurrence of a panic. Furthermore, joint distributions estimated over periods without panics will misestimate the degree of correlation between asset returns during panics. Under these circumstances, fear and disengagement by investors often result in simultaneous declines in the values of private obligations, as investors no longer realistically differentiate among degrees of risk and liquidity, and increases in the values of riskless government securities. Consequently, the benefits of portfolio diversification will tend to be overestimated when the rare panic periods are not taken into account.

As we make progress, hopefully, toward understanding asset-pricing mechanisms, we need also to upgrade our insights into the effect of changing asset values on GDP--the so-called wealth effect.

Although many aspects of this issue deserve attention, let me cite a few open questions of particular importance. Efforts to differentiate between realized and unrealized gains, and the propensity to leverage both, may afford a deeper understanding of the consequences of asset price change. And differentiating between gains that arise from enhanced profitability and those that reflect changes in discount factors may also be useful. The former may be more likely to be sustained, given the tendencies of discount factors to revert back to historic norms.

Moreover, it is evident that borrowings against capital gains on homes influence consumer outlays beyond the effects of gains from financial assets. Preliminary work at the Federal Reserve suggests that the extraction of equity from housing has played an important role in recent years. However, stock market values and capital gains on homes are correlated and, hence, their separate effects are difficult to identify. This is an area that clearly warrants further examination.

Finally, in the business sector, questions remain about the influence of equity prices on investment spending. In particular, Do all equity price movements--whether related to fundamentals or not--have the same effect on investment spending?

In conclusion, the issues that I have touched on this morning are of increasing importance for monetary policy. We no longer have the luxury to look primarily to the flow of goods and services, as conventionally estimated, when evaluating the macroeconomic environment in which monetary policy must function. There are important--but extremely difficult--questions surrounding the behavior of asset prices and the implications of this behavior for the decisions of households and businesses. Accordingly, we have little choice but to confront the challenges posed by these questions if we are to understand better the effect of changes in balance sheets on the economy and, hence, indirectly, on monetary policy.

---------------------------------------------------------------------- ---------- Footnotes 1 For example, Erik Brynjolfsson and Shinkyu Yang, "The Intangible Costs and Benefits of Computer Investments: Evidence from the Financial Markets," MIT Sloan School, mimeo, April 1999.

2 The Financial Accounting Standards Board (FASB) will require that the cost of repricing of options be charged against income starting later this year.

-- Andy (2000EOD@prodigy.net), August 29, 1999.

A funnel comes to mind when I think about current market conditions....big opening, small exit. Incidentally, any 401k'ers not already out by now are locked in through the end of the year as asset adjustments can only be made quarterly if the fund manager's fiscal end is Jan. 1st.

-- Charles R. (chuck_roast@trans.net), August 29, 1999.

Wow -- I've never followed Greenspan before...

Well, ah, OK, here's my little shtick:

See that guy in the shiny red monster pickup next to you in the K- Mart parking lot (OK so I live in a low-rent rural town), the one who looks like a factory worker, getting out with the three grimy-looking little kids? But that truck! -- his pride and joy, you can tell.

That's your IRA/401-k he's driving. Better hope he makes his payments. 'Cause your "savings", well, they're already SPENT!

-- jor-el (jor-el@krypton.uni), August 29, 1999.

Also for consideration, for those who missed it the first time or want to re-think: Gary North's Surviving All 3 Stages of a Complete Flight to Cash (Oct 1998), issue #32 of his "Reality Check" series:

Link

-- Jack (jsprat@eld.net), August 29, 1999.

The Jig is up.Time to pay the piper.Look out for that stampede of wild and crazy elephants all trying to get out of the same tiny exit.It will be ugly.

-- drken (drken@bubble.gone), August 29, 1999.

Thanks Chuck R., I didn't know that you would be locked in.

Currently I'm with the Prudent Bear and even if there is a crash before rollover I'm not at all sure how things will pan out regarding cashing out as I believe this will be the mother of all crashes...

thanks everyone for the comments and links, especially Jack - I'm gonna print out the GN Stuff tonight at work and re-read it carefully :)

-- Andy (2000EOD@prodigy.net), August 29, 1999.