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Nicklaus: Yellen has her ‘irrational exuberance’ moment

14 May 2015

(St. Louis Post Dispatch)

“The stock market is more fairly valued than it was three-plus years ago, but on the whole it is not overvalued,” says Ken Crawford, a managing director at Argent Capital Management in Clayton.”

May 12, 2015 (David Nicklaus)

When she said last week that stock prices “generally are quite high,” Janet Yellen was inviting everyone on a nostalgia trip to the 1990s.

Top Federal Reserve officials rarely express opinions about the stock market, as Alan Greenspan famously did in December 1996 with a speech about “irrational exuberance.”

Yellen sparked a 1.9 percent selloff in the Standard & Poor’s 500 index on Wednesday, as investors worried that she might back up her remarks with actions designed to bring down valuations. Our nostalgia trip, though, would indicate that investors have little to worry about.

 Greenspan at best was early with his pronouncement, which was followed by three years of soaring stock prices. Even by late 2002, after the technology bubble had burst and stocks lost half their value, they remained higher than when Greenspan sounded the alarm.

Then, as now, the Fed chair’s warning came after six years of almost uninterrupted investment gains. The S&P 500’s price-earnings ratio, a common measure of valuation, had crept up to 19.5 by the end of 1996, well above its long-term average of 15. Today, the ratio is 17.

Mark Keller, chief investment officer at Confluence Investment Management in Webster Groves, says that’s not high enough to be worrisome.

“It is characteristic of long bull markets that they get to above-average valuations and stay there awhile,” he said.

Today’s low interest rates make stock prices look even more reasonable. One rule of thumb says the price-earnings ratio and the yield on the 10-year Treasury note should add up to 20. Right now they add up to 19.3.

“The stock market is more fairly valued than it was three-plus years ago, but on the whole it is not overvalued,” says Ken Crawford, a managing director at Argent Capital Management in Clayton.

As prices climb, an investor who buys stocks today should expect returns of just 6 percent to 8 percent a year, says Kate Warne, investment strategist at Edward Jones. That’s a couple of points below the historical average.

“If valuations aren’t cheap, you have to lower your expectations for returns,” she said. “It doesn’t mean stocks are about to fall, which is what most people think when they hear the words ‘quite high.’”

Warne thinks stocks are “high but not overvalued,” and is still puzzling over why Yellen chose to express an opinion. One possibility is that the Fed chair is trying to prepare investors for more volatility as she and her colleagues begin to raise interest rates.

Or maybe Yellen’s comment was her way of responding to the Fed’s critics. After missing the housing bubble, the central bank needs to show vigilance about any market where prices are rising.

Also, Keller notes, “The Fed has come in for a fair amount of criticism that their policies postrecession have done more for asset values than for the economy. I think that has stung them a little bit.”

If irrational investors, not super-low interest rates, are behind the run-up in stock prices, that takes the Fed off the hook for the growing divide between capitalist-class haves and working-class have-nots.

Whatever her motivation, the current Fed chair has now had her irrational-exuberance moment. Greenspan didn’t turn out to be a very good stock market forecaster, and there’s no reason to think Yellen will be any better.