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Monday, September 24, 2007

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Alan and Ben 9/24/07

A significant amount of discussion has been targeted towards the comparison of Alan Greenspan and Ben Bernanke. Indeed, there are great reasons to dissect the similarities and differences of both men’s particular styles in managing fed policy. The implementation of FOMC policy has great repercussions to global financial markets. However, as traders we must remember that the Fed determining monetary policy is both science and art yet the market is not keenly aware of that fact. The degree to which each is used by the Fed depends largely on the person wielding the sword. Therefore, it is important to examine the differences of how fed policy will be administered under the new chief Ben Bernanke versus Alan Greenspan.

Alan Greenspan has frequently been referred to as maestro. Barely three months into his new job as Fed chief in 1987, was he tested with the October 19 crash. Most historians would agree that Greenspan handled that crisis and subsequent financial debacles over the years with incredible expertise. Greenspan is a master of understanding the complexities of the financial markets and how they are entwined with the real economies. He is also unmatched in his ability to communicate his intentions in a way that kept market watchers informed yet unable to predict his next move. He is widly recognized for implementing a strategy that helped Foster economic growth through the use of low short term interest rates due to his staunch belief that increased productivity from the advent of technology was a sustainable force in the global economy. Importantly, he believed that the high productivity levels that we enjoyed in the late nineties were instrumental in keeping inflation at bay. Greenspan fully embraced this concept and was therefore less concerned about being preemptive in fighting future inflation. A more preemptive Fed would have hindered economic prosperity at that time.

Many people fail to recognize how much art as opposed to science Greenspan used in deciding short term monetary policy. He was not afraid to take swift action when the financial markets called for it regardless of the long term affects to the real economy that the inflation hawks screamed about. Often, he would adjust short term interest rates inter meeting based on his gut feeling of how the real economy might get affected by short term stress in the financial markets. He felt comfortable taking strong action due to his overall comfort level with long term inflation. In other words, he felt that he had the maneuvering room to address short term hiccups whenever they occurred. Essentially, Greenspan handled monetary policy much like a short-term trader handles volatile stocks in a portfolio. He had tremendous confidence to utilize his instincts and commanded respect in the financial community to put policy into action without being challenged. Ultimately, this became known as the Greenspan Put.

Ben Bernanke is perhaps the polar opposite of Alan Greenspan in many ways. Ben is much more of an academic than Greenspan and therefore administers fed policy in a much more scientific way. Economically, the key difference between the two men and their economic philosophies has to do with their belief in the importance of expectations theories. Simply, research around expectations theories imply that markets adapt to economic policies. How well it adapts is dependent on the market’s view of the level of commitment to the policy by its creators. Greenspan, in his nearly 20 years as fed chief, shied away from intermediate term expectations policy and relied much more on addressing short term hiccups due to his overall comfort with the long term economic outlook.

Having a new Fed chief (Ben) who demands that markets adapt to fed policy based on intermediate economic forecasts for growth and inflation will have profound market implications that are different than the Greenspan era... In essence, the markets are likely to go through bouts of love and hate relationships with this new Fed chief. We can expect that this Fed chief will sometimes be perceived as a rock star much like Mr. Greenspan and other times like a stubborn mule unaffected by the misery that the financial markets may be experiencing at any given time. The threat of short term dislocations in the financial markets and possible spill over to the real economy will not prompt this new Fed chief to act until he sees actual evidence that threatens his intermediate term forecasts. In other words, the new fed chief will only appease the markets when there is clear evidence that the real intermediate economic forecast is being negatively affected due to stress in the Financial System, unlike Mr. Greenspan who played the financial markets with rate adjustments almost at his whim.

All in all, Alan Greenspan had the approach of a short term stock trader and the control of a maestro, while Ben Bernanke has the stuffy feel of an academic, frequently satisfied to delegate decisions to the consensus of the board of fed governors. This also holds true for the intermediate-term economic forecast that is currently in place at the Fed which is the lynch pin of current monetary policy. Market participants need to understand this key difference between Alan Greenspan and Ben Bernanke in the implementation of Fed policy going forward.

If you Held a Taser to Our Head:
The Fed recently acted aggressively in the face of the current credit crises by reducing the short term target rate by 50 basis points. Thankfully, recent economic data pointed to a marked slowing of the economy. Had this not been the case, the financial stress in the stock and bond markets would likely have not been enough to warrant such dramatic action from this new Fed chief. Your friendly neighborhood Kcap team firmly believes that Greenspan would have acted aggressively even if the economic data did not show a noticeable slowdown in the economy.

The rally that has been taking place in the stock market over the past 3 to 4 weeks has largely run its course. Perhaps a little more upside is in store due to the psychological boost from the aggressive fed action. However, make no mistake about it; this credit crisis is not over and has many more months of pain to inflict on the Financial System. When key overhead resistance levels are hit on the major averages (specifically around the all time highs), the market will be vulnerable to more bad news regarding the credit crisis….. And yes there’s plenty more bad news to come. In essence, the market is experiencing a counter rally in a larger downtrend. Therefore, we firmly believe that we have not yet seen the lows in the NASDAQ or the Dow. Once the countertrend rally has played itself out, the market will be ripe for aggressive short selling again.

Hope all is well.

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