Last week Federal Reserve Chair Janet Yellen, speaking at a conference at the International Monetary Fund’s headquarters, warned that “equity market valuations at this point generally are quite high. There are potential dangers there.” To be frank, I found her comments to be a little disingenuous for a couple of reasons.
Firstly, while delivering her semiannual policy report before the Senate Banking Committee last July she stated, “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.” This assertion defends her earlier testimony that the federal funds rate would not be raised any time soon, even after quantitative easing (QE) ended. So let’s take look at how equity valuations have changed since that time: since July 2014 the S&P 500 is up about 7%-not a dramatic change, by my account. To measure the actual valuation of the market, let’s consider the Schiller P/E (price/earnings) ratio. I am using the Schiller P/E ratio versus a simple P/E ratio to account for the business cycle. Currently, the ratio stands at 27.29. In July of last year, the Schiller P/E ratio stood at 25.82. Therefore, it is now a little higher. However, the historic mean of the ratio is 16.60. To say that 25.82 is within historical norms given a 16.6 average, but that a ratio of 27.29 is “quite high” is a little insincere.
Secondly, her predecessor, Ben Bernanke, whose policies she has followed, stated numerous times that QE was meant to move asset prices higher to stimulate the economy in order to achieve the Fed’s dual mandate of price stability and maximizing employment. In other words, through QE1, QE2, and QE3 the Fed actively pushed stock prices higher and now the Fed is complaining that prices are too high.
Since none of this is news to the Fed Chair, why did Yellen opine about equity valuations? I believe she is simply testing market psychology and preparing investors for the upcoming rate increase. While we do not expect a large increase, we do expect a quarter point hike later this year. Recently, the stock market has been trading on bad news is good and vice versa. When data is released indicating the economy is slowing, markets have reacted favorably, assuming any rate hike will be pushed off further into the future. I think she feels if the market is not ready, the increase will spell trouble for stocks and the Fed will have to step in once again. This is something that no one wants. Let the markets determine prices, not the Fed. Risk is an important part of the equation.
I am not suggesting that the Fed should not have stepped in after the financial collapse, but as I have said in a previous blog click here to view the blog, I believe its policies helped cause the problem, or at least made them worse.
As far as equity valuations, they are high versus historic norms, but they have also been higher. Click here to view my previous blog discussing equity valuations. For investors, trying to guess when to get in or out of stocks based on Schiller’s P/E or any other statistic is a fool’s game. Investors should focus on their long-term goals and build a portfolio with the appropriate level of risk to meet those goals while allowing them to sleep at night.
Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.
Rick Cloutier, PhD, CFA is the Chief Investment Strategist for Washington Trust Bank with over 25 years of portfolio management and investment experience. He is responsible for directing the portfolio management, research, and trading activities for the bank’s multi-asset class strategies. He is also responsible for overseeing the client portfolio manager team and portfolio analytics team. Rick has written numerous articles for Investopedia and wrote a weekly column for the Fall River Herald News in Massachusetts. His research has appeared in numerous journals, including the Journal of Investment Management and Financial Innovations, the Journal of Business Management and Economics, and the International Journal of Revenue Management. He provided a nightly commentary on WALE radio and authored the novel Caveat Emptor. Rick earned his BS from URI, MBA from Boston University and PhD from SMC University.