Three months ago, Janet Yellen was asked during the last FOMC press conference if she was “worried about bubbles in the economy because of our prolonged low interest rates?” Her 169-word response was the following:
Yes. Of course we are worried that bubbles will form in the economy and we routinely monitor asset valuations, while nobody can know for sure what type of valuation represents a bubble, that’s only something one can tell in hindsight, we are monitoring these measures of valuation and commercial real estate valuations are high. Rents have moved up over time, but still valuations are high, relative to rents. And so it is something we’ve discussed. We called this out in our monetary report and in other presentations and we are, in our supervision with banks, and I indicated, we have issued supervisory guidance to make sure underwriting is strong on these loans and this is something that we’ve looked at in stress tests, the larger banks to see what would happen to their capital positions and to make sure that they hold sufficient capital. And of course, I think the soundness and state of the banking system has improved substantially, but of course we are focused on such things.
Fast forward to today, when Yellen was served a variation of the same question – one which included mentions of both “bubble” and “irrational exuberance” – by a Fox Business reporter, who asked: “the Dow is about to hit 20,000. It’s up substantially since the election apparently on investor optimism about the potential impact of President-elect Trump’s policies on the economy and an approving economy. I wonder if you share that optimism, number one. And if not, are we seeing a bout of perhaps irrational exuberance right now or are you concerned at all about a bubble in equity prices that could create some financial instability in the economy?
I don’t want to comment on the level of stock prices. They may have been boosted by expectations about tax policy, possible cuts in corporate tax rates that have been much discussed, or by expectations about growth, possible reductions in down side risk to the economy. But these are things that market participants are trying to view along with the likely paths of interest rates, and I think all of that factors in to movements in stock valuations. But I don’t want to offer a view as to whether they are appropriate.
The reporter did not, however, give up and continued his questioning:
On equity prices you talked about whether or not evaluations are still within historical ranges and norms. Is Dow 20,000 kind of within the historical norms, are you comfortable with that?
To which, a frustrated Yellen responded:
Rates of return in the stock market relative to – remember that the level of interest rates is low – and taking that into account. I believe it’s fair to say that they remain within normal ranges.
So i) Yellen did not wwant to comment on whether stock prices are appropriate and ii) when pressed, she confirmed that yes, they are.
Which is surprising, because over a year and a half ago, in May 2015, Yellen’s view was quite different. As Bloomberg reported at the time, Yellen – speaking at a Washington forum – said that “I would highlight that equity-market valuations at this point generally are quite high,” She then added “they’re not so high when you compare the returns on equities to the returns on safe assets like bonds, which are also very low, but there are potential dangers there.”
How does the market valuation in May 2015 compare to December 2016 from a forward PE multiple basis? Here is the answer:
So since Janet appears confused, here is a quick primer from Bank of America laying out all the ways that stocks are currently overvalued. According to the 20 most popular metrics, the stock market is currently overvalued based on 17 of them by as much as 76%.
Don’t believe Bank of America? Here’s Goldman showing that as of November 28, the S&P is expensive based on most metrics. It is even more expensive as of today.
So what is a trader to do: ignore the fundamentals and trust Yellen when she says that “it’s fair to say that valuations remain within normal ranges”, or open one’s eyes and watch as the world’s most overvalued “market” keeps grinding higher? We will know the answer as soon as the next BTFD opportunity presents itself.