Party Like It's 1999?

http://www.ft.com/cms/s/0/434df73c-714b-11dc-98fc-0000779fd2ac.html

Excerpts

Recent history, in turn, suggests that such "emergency" rate cuts by the Fed have the effect of inflating asset price bubbles. That is potentially great news for equity investors.

In October 1998, when the Fed under Alan Greenspan was forced to cut the Fed funds rate to bring back liquidity to the markets after the near-meltdown of the Long-Term Capital Management hedge fund, the result was also to stimulate markets that had not needed the help. Large technology stocks, and the growing wave of dotcoms, were the greatest beneficiaries. The Nasdaq Composite index gained 40 per cent in three months, and tripled in less than 18 months as it roared through 1999. This helps explain why many in the market now refer to stocks as "partying like it's 1999".

There is another example. In 1987, after Alan Greenspan's Fed cut rates to avert a crisis in the wake of the Black Monday stock market crash, the response was again a bubble. That time, however, it was in Japanese stocks, which more than doubled in the two years after Black Monday, before beginning a long drawn-out collapse.

"This is a classic event, which happens every decade. You have the Fed tightening, then there's some kind of crisis, and then the Fed bails out, and when they do there's another leg up for someone," says Nick Raich, director of equity research at National City bank in Cleveland. "Each time it's a different sector than it was in the previous decade."

Traders know that both these incidents created bubbles that eventually burst. But they also know that in both 1998 and 1987, the euphoria created by the rate cuts lasted more than a year - plenty of time to make strong short-term profits.

Teun Draaisma, European equity strategist at Morgan Stanley, advocated selling in June, and then aggressively re-entering the market in August, for exactly these reasons. He says another "equity mania" is possible, with retail investors piling in and companies indulging in strategic mergers and deals. "If we are right, then equities could be set for a big, big rally," he says. "Bulls will say that this uptrend is unbreakable after all the trouble that has been thrown at it. Emerging markets will be seen as the new growth engine that cannot be derailed."

He also predicts that the episode will "end in tears" - but that still leaves time for investors to make fat profits in the interim.

As everyone is working on the same assumptions, gains could be limited this time. Tobias Levkovich, US equity strategist at Citigroup, who has been strongly optimistic on the market for most of this year, sounds a note of caution. "As most investors are now searching for performance data on past beneficiaries of Fed actions," he says, "we suspect some 'institutional herding' may arbitrage away much of the opportunity fairly quickly."

The Fed itself is also acutely conscious of what happened in 1999. If crisis in the money markets is indeed averted, the Bernanke Fed might well move much quicker than the Greenspan Fed did to raise rates and avert the risk of a big bubble.