Federal Reserve Worried about Stock Market Bubble

Federal Reserve Chair Janet Yellen announced recently that she will leave interest rates unchanged in the range of 0.25% to 0.5%. The Fed signalled it could still tighten its monetary policy by the end of year as the labor market, she says, is improving. The Fed last raised rates back in December for the first time in nearly a decade. The Federal Reserve cited a stronger U.S. economy as the reason for the increase. The economy was doing so well the Fed signalled that it would increase rates four times in 2016. That didn’t happen. The economy wasn’t as strong as initially thought. In January, the global markets plunged. While the stock market eventually rebounded, the last thing the Federal Reserve wants to do now is raise rates prematurely and create more stock market volatility and derail an already weak U.S. economy. On top of that, the Fed is concerned about a stock market bubble, similar to the one that caused the Great Recession and financial crisis in 2008. “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,” Yellen said.1

Stocks Most Overvalued Since Tech Bubble Burst

While Wall Street maintains that the markets are fairly valued, the fact is, the last time stocks were this overvalued was right before the tech bubble burst. Stocks may be near record levels but the valuations are out of step with lukewarm earnings growth. In fact, the S&P 500 is knee deep in an earnings recession. Quarterly profits in the S&P 500 are headed for a sixth straight decline in the upcoming third quarter. This will match the longest earnings recession on record. In light of weak earnings, it’s difficult to justify the record-high valuations. Two leading indicators suggest the stock market is severely overvalued. According to the Shiller P/E ratio, the S&P 500 is overvalued by around 59%. The index is currently sitting at 26.57; the historical average is 16.7. This means that for every $1.00 of earnings a company makes, investors are willing to shell out $26.57. The ratio has only been higher three times: 1929, 2000, and 2007. Each time a high ratio was followed by a stock market crash.2 The second indicator suggesting markets are seriously overvalued is the market cap to GDP (gross domestic product) ratio. Also called the Warren Buffett Indicator, it compares the total price of all publicly traded companies to GDP. The implication is that stocks and their valuations should bear some relationship to the benefits of investing or not investing. A reading of 100% suggests U.S. stocks are fairly valued. The higher the ratio is over 100%, the more overvalued the stock market. And the lower the ratio is under 100%, the more stocks are undervalued. The current reading is 123%. The ratio has only been higher once since 1950, that was in 1999. Eventually, stocks and valuations will have to run in step. That means U.S. companies are going to have to report huge double-digit gains in earnings in the company quarter or stocks will need to retrace. In light of weak global growth and forecasts, the latter seems more probable.

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  1. “Yellen Excerpt: Always Concerned With Any Asset Bubbles,” MNI web site, September 21, 2016; https://www.marketnews.com/content/yellen-excerpt-always-concerned-any-asset-bubbles.
  2. “Online Data Robert Shiller,” Yale University web site; https://www.econ.yale.edu/~shiller/data.htm, last accessed September 22, 2016.