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Yellen Sees Rational Exuberance

Yellen Sees Rational Exuberance
(Dollar Photo Club)

Wednesday, 18 October 2017 08:33 AM Current | Bio | Archive

.The world’s major central bankers met on Sunday at the Group of 30 International Banking Seminar in Washington, DC. Fed Chair Janet Yellen spoke.

Her prepared remarks were a rehash of her recent pronouncements.

Nothing new here, so move along, folks.

More interesting were her impromptu remarks as reported by the 10/15 WSJ: “While asset valuations today are ‘high in historical terms,’ that may reflect investors’ expectations of a ‘new normal’ of lower interest rates for the foreseeable future than in the earlier decades, she said, adding that financial stability risks remain ‘at a moderate level.’”

Could it be that Yellen is reviving the Fed’s Stock Valuation Model? Sure seems that way.

It all brings back lots of nostalgic memories for me:

(1) Greenspan’s question. The valuation question isn’t as existential as Hamlet’s “To be or not to be” soliloquy. The question is: “How can we judge whether stocks are overvalued or undervalued?” I’ve been working on answering this question for many years. I started thinking more about it after Alan Greenspan, former chairman of the Federal Reserve Board, famously asked the valuation question near the end of a 12/5/96 speech, “The Challenge of Central Banking in a Democratic Society.”

This was the first time any Fed chairman had ever mused publicly about the impact of monetary policy on the interaction of the inflation rate for goods and services and the valuation of equities. Notice that he asked a question rather than making a statement on valuation: “Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But 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 over the past decade?”

(2) Greenspan’s answer. After Greenspan famously worried out loud for the first time about irrational exuberance, his staff apparently examined various stock market valuation models to help him evaluate the extent of the market’s exuberance. One such model was made public, albeit buried in the Fed’s 7/22/97 Monetary Policy Report to the Congress that accompanied Greenspan’s Humphrey–Hawkins testimony. It included a chart showing a strong correlation between the US Treasury 10-year bond yield and the S&P 500 forward earnings yield—i.e., the ratio of the year-ahead forward consensus expected operating earnings to the price index for the S&P 500 companies (Fig. 1). The monthly chart compared the two series starting in 1982 and extending through July 1997.

This model was first developed in the mid-1980s by Dirk van Dijk at I/B/E/S, which had started compiling the forward earnings series on a monthly basis during September 1978. I first wrote about my discovery of the “Fed’s Stock Valuation Model,” as I dubbed it at the time, in my 8/25/97 commentary, a week after noticing it in the 7/22 report to Congress. In his testimony, as so often in the past, Greenspan played the role of a “two-handed economist.” I pointed out, though, that he was clearly inclined to be bullish: “Without question, the exceptional economic situation reflects some temporary factors that have been restraining inflation rates. In addition, however, important pieces of information, while suggestive at this point, could be read as indicating basic improvements in the longer-term efficiencies of the economy.”

(3) Long-term earnings growth. The Fed’s Model showed that stocks were fairly valued at the end of 1996, but 17.8% overvalued during July 1997 (Fig. 2). By June 1999, stocks were 42.5% overvalued relative to bonds. Along the way, in a 9/5/97 speech at Stamford University, Greenspan explained: “And the equity market itself has been the subject of analysis as we attempt to assess the implications for financial and economic stability of the extraordinary rise in equity prices—a rise based apparently on continuing upward revisions in estimates of our corporations’ already robust long-term earnings prospects.”

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.

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Could it be that Yellen is reviving the Fed’s Stock Valuation Model? Sure seems that way.
yellen, rational, exuberance, fed, invest
Wednesday, 18 October 2017 08:33 AM
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