Equity investors, says one leading US fund manager, quoted in a prominent national newspaper this week, are “having a hard time” finding anything fundamental to worry about, given the fact that the Federal Reserve has “made plain that we will have easy money for years to come”. Perhaps I should get out more – or at least spend time with a wider sample of the investment community, as my experience is quite the reverse. Most thoughtful investors I speak to are having a hard time not worrying about the implications of the recently reiterated public policy stance of the 100-year-old US central bank.
Jant Yellen‘s appearance before the Senate Banking Committee ten days ago, the first step on her path to formal confirmation as the next head of the Federal Reserve, has only heightened these anxieties. One prominent critic, Andrew Smithers, the robustly independent London market analyst, whose latest book The Road To Recovery is a closely argued plea for central banks to change their current policy approach before it is all too late, does not pull his punches in assessing her performance that day.
“Her performance”, he told me this week, “was disgraceful”, most notably for her suggestion that the equity market was not overpriced because the one-year forward p/e ratio was still close to its historical average. “She must know” he went on “that she is talking nonsense”. It has been well documented that a one-year forward p/e ratio has no predictive value whatever; and if she did not really know this well-documented fact, he says, her husband, a distinguished academic collaborator with the recent Nobel economics prize-winner Robert Shiller, could surely have disabused her.
Prof Shiller of course has done more than anyone to popularise the cyclically-adjusted p/e ratio as a measure of the risk in current equity market valuations, and on that measure the current readings still point to the US markets being significantly overvalued. Tobin’s q, the measure that Mr Smithers himself favours as the most reliable guide to expected long term equity market returns, is also nearly 70% above its long term norm.
Ms Yellen has fared little better in the estimation of another dissenting fund manager, the combative founder of GMO, Jeremy Grantham, in his latest quarterly letter. Noting her years at the Federal Reserve under the leadership of Greenspan and Bernanke, he observes that Ms Yellen “has happily gone along with the failed Fed policy of hoping madly for a different outcome despite repeating exactly the same thing”.
Neither he nor Mr Smithers see much chance that the Federal Reserve will abandon its policy of loose monetary policy any time soon; indeed, says the former, the central bank “has started a policy which they cannot end. The consequences of ending it are unacceptable to them”. The fund manager Terry Smith and economist Peter Warburton are among a number of others who to my knowledge share that view. According to Mr Smith, in a recent interview, the chances are that we will have “QE 99” before the policy has run its course.
If the policy of seemingly endless monetary accommodation were riskless, it might not matter so much. But that is patently not the case, as the Bank for International Settlements and many others have pointedly noted. It is not just that monetary stimulus has failed to stimulate a return to prior levels of economic growth. The more the markets remain in thrall to central bank policy (and just as importantly, vice versa), and the more elevated asset prices become as a result, the greater the risk of an eventual severe market correction that in turn risks a rerun of the 2008 financial crisis.
This risk to financial stability is one that Ms Yellen acknowledged in her testimony, but appeared to dismiss as minimal in the current environment. If this worst case outcome does materialise in a year or two’s time, however, she will inevitably find herself open to the charge of being either ignorant or complacent about the risks she seems intent on choosing to run.
Such strictures might seem unduly harsh for someone who has not yet even been confirmed in her job. Few analysts realistically expected Ms Yellen to sound a discordant note in her testimony. Her words and choice of market valuation criteria were clearly carefully chosen. Perhaps her policy will change when she has assumed the reins of office. She is entitled to point out that many of the critics of Fed policy have been among the principal beneficiaries of the Fed’s accommodative policy stance over the past four years.
In the short term of course, assuming a continuation of policy, there is no obvious reason for equity markets to reverse their upward path. Momentum in markets is a wonderful thing as long as it lasts. Even Mr Grantham says he suspects that the US market, whether overvalued or not, could climb a further 20%-30% in the next year or so. Most of the classic signs of a late cycle equity market are beginning to appear, but we are still some way from the kind of euphoria that Sir John Templeton characterised as typical of a secular market top.
All we do know is that the Federal Reserve under Ms Yellen will not be falling over itself to “take away the punchbowl” any time soon. Its reaction function, to use the jargon of the day, has become consciously and openly reactive, both to economic data and to financial market prices. On the evidence so far, it seems that Ms Yellen will be late to any party that is going on. Enjoyable as the ride has become, the one thing you cannot argue – pace the fund manager I quoted at the outset – is that nobody is worried about where the current rise in equity markets might end.
Jonathan Davis 