What Janet Yellen Doesn’t Know About Stocks
On Wednesday, Federal Reserve Chair Janet Yellen rattled the market when she said “equity market valuations at this point generally are quite high” and that raises “potential dangers.”
Stocks promptly sold off on her comments. For about 90 minutes.
They began to recover as traders and investors asked themselves, “What the heck does Janet Yellen know about stock valuations that the rest of us don’t?”
She would be well advised to take her cue from Alan Greenspan, a predecessor who learned the hard way.
On December 5, 1996, then-Fed Chair Greenspan asked, “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan the past decade?”
The market was closed at the time but the message was received. The Dow gapped down 2% at the opening of the next day. But then rallied... for 3 1/2 years.
Don’t get me wrong. Greenspan asked precisely the right question. How do we know when asset prices are irrationally exuberant?
History provides a clear answer: when both valuations and optimism are extreme. Whether we’re talking about gold in early 1980, Japanese equities in 1989, Internet stocks in 2000 or U.S. home prices in 2006, prices weren’t just beyond rational justification. Sentiment was euphoric, too.
Let’s start with valuations today. Since 1929 - a period that includes the ultra-low prices of the Great Depression - U.S. stocks have sold for an average of 15.5 times trailing 12-month earnings. Today the S&P 500 sells for 18 times earnings.
Higher than average, yes. But extreme? No. Especially with interest rates near zero, making it easy for businesses to borrow, consumers to spend and investors to scoff at the yields on bonds and cash.
Sentiment is underwhelming as well. Investment great John Templeton famously said that bull markets are born on pessimism, grow on skepticism, peak on optimism and die on euphoria.
Is your feeling today that most people are wildly optimistic about the future of the U.S. economy and stock market?
Most people I talk to are somewhere between unenthusiastic and glum. That, by Templeton’s lights, places us in the “skeptical” range. (Recall that we had the abject pessimism a few years ago when people thought the world was coming to an end. That - as Templeton would have pointed out - was a superb buying opportunity.)
Bubbles don’t appear without euphoric sentiment and a powerful sense of certainty. Recall 1980’s “Hyperinflation is here to stay.” 1989’s “Japan Inc. is going to take over the world.” 2000’s “The Internet changes everything.” Or 2006’s “Real estate always goes up.”
Could stocks fall from here? Of course they could. Bear markets sometimes start when valuations are higher than average. But they have also started when they are lower than average.
Sometimes bear markets begin when the Fed raises interest rates. Sometimes six months later. And sometimes before.
As chair of the Federal Reserve, Janet Yellen is privy to a tsunami of economic data and a lot of smart people who interpret it.
But are they smart enough to know what they don’t know? Apparently not or Janet Yellen wouldn’t be flapping her gums about stock prices.
The Federal Reserve has persistently misestimated the strength of the economic recovery, the rate of joblessness and the level of inflation. It didn’t - and couldn’t - predict the plunge in oil prices, the rally in the dollar or all-time record corporate profits.
Yet Janet Yellen believes she can tutor the rest of us about stock valuations.
I don’t think so.
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