Taking Greenspan Seriously

Last week, Fed Chairman Alan Greenspan delivered one of his most stern warnings yet on the health of the U.S. financial system. His biggest concern seems to be the increasing amount of risk investors are willing to take, even though returns are likely to be muted. “Any onset of increased investor caution could cause housing and stock prices to drop and force investors to liquidate assets to repay debts. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums,” he said.

An apt translation of Greenspan’s comment? “In a rising rate environment, there is little margin for error.” If something goes awry–another terrorist attack, or weaker earnings, or an inverted yield curve–the stock market is much more likely to take it on the chin.

Last month’s market action is a case in point. A number of exogenous factors, including a dramatic spike in crude oil prices, caused stocks to give up a big chunk of July’s impressive gains. This occurred even though market fundamentals–including earnings, economic growth, and corporate balance sheets–are improving.