SERIOUS MONEY:Alan Greenspan backed developments in the US housing market that have since proved deadly, writes Charlie Fell

THE GREATEST secular bull market in US stock market history came to an end in spring 2000. However, it has taken the savage decline in prices over the past 15 months to force investors to question the fanciful economic thinking previously accepted as conventional wisdom despite the lack of theoretical foundation or empirical support.

Wholesale belief in the “Goldilocks” economy and its positive impact on asset prices spawned a belief in all things Wall Street. That gave birth to a self- regulating market-based financial system of ever-greater fragility.

The dubious economic model has since failed and the battle to fend off a deeply destructive debt spiral via unprecedented monetary easing and a soon-to- be-revealed fiscal stimulus is in full swing. However, the ability to generate a self-sustaining economic recovery is doubtful.

The US economy enjoyed more than two decades of almost uninterrupted growth in prosperity following the tough medicine delivered by former Federal Reserve chairman Paul Volcker, who found himself replaced for political reasons by Alan Greenspan in 1987.

The “great moderation” that began under Volcker gathered pace under Greenspan but the populist successor went one cycle too far following the collapse of the late-1990s stock market bubble that saw overextended US households badly burnt.

Greenspan kept interest rates far too low for far too long. At one stage, rates were three percentage points below that suggested by the respected rule developed by John Taylor at Stanford. Greenspan wasn’t done though, as he encouraged developments in the housing market – from adjustable- rate mortgages to complex structured finance products – that have since proved deadly.

The perilous state of US household finances was clear in the Federal Reserve’s survey of consumer finances in 2004, but this was ignored as household consumption and ever-greater indebtedness in the face of stagnant real wages proved vital to lift a struggling economy.

The survey shows that the middle classes experienced no rise in wealth from 2001 to 2004 despite the surge in home prices as debt-to-net worth rose by more than 15 percentage points to 62 per cent and the debt/income ratio increased by more than 40 percentage points to 141 per cent. The rise in consumer indebtedness is staggering, with more than 60 per cent of the increase since the early 1980s occurring from 2001 to 2004.

Belief in the “great moderation” gained traction as the supposed leadership from Wall Street to Washington converted ordinary US households. They came to believe that asset-price gains were permanent and stepped up their borrowing rate, made all the easier by a steady stream of financial innovations.

Household debt as a share of gross domestic product jumped almost 30 percentage points in seven years as consumers bought into the fallacy that asset-based gains negated the need for income savings.

The losses stemming from such beliefs are staggering – the percentage decline in household wealth over the past year is the largest since records began.

The US’s asset-based economy has moved into reverse and the unemployment rate has jumped almost three percentage points from the cycle low. Taking into account the peculiarities that come with these figures, the actual rate of unemployment is in double digits and close to depression levels.

Rising unemployment and massive wealth destruction, alongside concern over the security of pension income from underwater defined-benefit schemes, mean that aggressive fiscal and monetary policy can only cushion the blow stemming from baby-boomer deleveraging.

The deleveraging process cannot be reversed, only contained. While stock prices have dropped to attractive levels, the persistent bullishness of money managers is cause for concern.

Valuations have dropped below historical averages, but only just. As records show, they must be sustained below average for the mean to be restored.

Stock prices are likely to range trade for a protracted period, with the SP oscillating between 800 and 1,000.

The road to nowhere and the tactical trading it requires demand active investing and not what is effectively indexation, which is practised by many.