Yellen: On Bubbles

Once the Fed starts to normalize monetary policy, stocks could stumble or even tumble on fears that rising interest rates will pose more of a competitive challenge for stocks or, worse, cause a recession. However, in her press conference last week, Fed Chair Janet Yellen reiterated that when rate hikes start they are likely to be small and gradual:

Once we begin to remove policy accommodation, we continue to expect that--in the words of our statement--"even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run."

There’s certainly no reason for monetary policymakers to raise interest rates in an effort to bring down inflation given that inflation remains below their 2% target. If so, then the current economic expansion isn’t likely to end anytime soon as a result of tighter monetary policy.

Last Wednesday, at Fed Chair Janet Yellen’s press conference, Peter Barnes of Fox News asked:

I wanted to check in again with you on whether or not you see or have any concerns about bubbles out there in the economy, particularly the financial markets, debt and equity markets and I want to refer to your most recent Monetary Policy Report to Congress last month in which you said overall equity valuations by some conventional measures are somewhat higher than their historical levels, valuation metrics in some sectors continued to appear stretched relative to historical norms. In the same report last year, in July, the reports specifically mentioned biotech and social media stocks as being substantially…stretched. Do you still feel that way, and can you comment on bubbles and particularly these sectors?

Her answer was short and a bit curt:

Well, I don't want to comment on those particular sectors. You know, as we said in the report, overall measures of equity valuations are on the high side, but not outside of historical ranges. In some corporate debt markets, we do see evidence of unusually low spreads. And that's what we referred to in the report.

Let’s have a closer look:

(1) Sure enough, the July 2014 report stated:

Nevertheless, valuation metrics in some sectors do appear substantially stretched--particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.

In her prepared remarks for her July 15, 2014 congressional testimony on monetary policy, Yellen said:

While prices of real estate, equities, and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms. In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk.

During the Q&A, she warned about biotechs and social media stocks being overvalued as well.

(2) In the February 2015 report, there was no mention of any specific “stretched” sectors, though:

“[o]verall equity valuations by some conventional measures are somewhat higher than their historical average levels, and valuation metrics in some sectors continue to appear stretched relative to historical norms.

Now, during her latest press conference, Yellen said, “equity valuations are on the high side, but not outside of historical ranges.”

Yes, P/Es are on the high side of their historical ranges. Yes, they are not outside their historical ranges. However, doesn’t the high side of the historical range suggest that stocks might be a wee bit overvalued? Back in July of last year, Yellen said that valuations seemed a bit “stretched.” Now she doesn’t want to discuss the subject.

Yellen’s number-one priority remains the labor market. She acknowledged that it has improved, but said last week that she sees “room for further improvement.” If postponing or slowing monetary normalization is necessary to achieve her goal, so be it, even if it leads to a melt-up in stocks.

On Friday, a day after retiring as president of the Federal Reserve Bank of Dallas, Richard Fisher appeared in an interview on CNBC. He warned:

Are we vulnerable in my personal opinion to a significant equity market correction? I do believe we are, and the reason for that is people have gotten lazy. They've depended totally on the Fed.

He added that in the event of a market correction, the Fed should not intervene because the market is “hyper overpriced.”

Fisher, unlike Yellen and his other colleagues at the Fed, has had some experience actually managing money. His resume includes stints at Brown Brothers, where he was assistant to former Undersecretary of the Treasury Robert V. Roosa. He specialized in fixed income and foreign exchange markets. From 1978 to 1979, he served as Special Assistant to Secretary W. Michael Blumenthal at the US Treasury, where he worked on issues relating to the dollar crisis. In 1987, Fisher created Fisher Capital Management and a separate funds management firm, Fisher Ewing Partners, managing both firms until 1997.

(Based on an excerpt from YRI Morning Briefing)