Fed not going to attack equites

In the past 24 hours, Bloomberg has reported twice that stocks are resilient.  The first was a news story arguing that stocks don’t seem to go down even when there is a bad news.

And the second was a BV piece by Mohamed El-Erian urging markets to ignore risks that his headline writer suggests they already are ignoring.

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Probably best to dismiss the fears he claims markets don’t even have. Sound.

There was some great purple prose in the El-Erian piece that you might want to take a moment to enjoy.  But it too was basically: markets should be lower and are not.  On technical grounds, that could be taken as contrarily bullish for the short run.

In contrast, Business Insider reports this morning that the Fed has fired off a “stark warning” about overvaluation in markets.  Presumably the Fed’s view is important, not just because they are smart, but because they have the power to do something about that overvaluation.

What is going on here? Are markets resilient or overvalued and about to attract some unwelcome attention from the Fed.  I have a few thought on that.

First and least controversially, the bull and bear takes are not actually opposing sides of the one argument.  The bulls are (were?) mentioning a technical condition that they think they see, which presumably would be relevant at short horizons.

The Fed minutes, in contrast reference a fundamental: valuation, which is a weak force and one that applies at longer horizons.   Historically, US stocks have done better when starting from  low valuations.  (Amusingly, though, over long horizons stock have always done well. [1]  Resolving that is beyond my pay grade. Requires taking a strong view on the importance of survivorship bias.)

The second point is more controversial, oddly to me, but it is one on which I have a strong view.  I would assign zero importance to the idea that the Fed would ever actually do anything about equity market overvaluation, even if the minutes were to imply that policy makers were expressing concern.

Of course, the highlighted passage from the minutes reflects a concern only of the staff, which weakens its importance, presumably even among those who wrongly believe the Fed might tighten if policy makers were concerned about this.

The staff provided its latest report on potential risks to financial stability, indicating that it continued to judge the vulnerabilities of the U.S financial system as moderate on balance. This overall assessment incorporated the staff‘s judgment that, since the April assessment, vulnerabilities associated with asset valuation pressures had edged up from notable to elevated, as asset prices remained high or climbed further, risk spreads narrowed, and expected and actual volatility remained muted in a range of financial markets. However, the staff continued to view vulnerabilities stemming from financial leverage as well as maturity and liquidity transformation as low, and vulnerabilities from leverage in the nonfinancial sector appeared to remain moderate.

Emphasis added

That is a thorny discussion on which I have been plenty tedious over the years. For now, let me just say that I am so far batting 1000 on that and that the most eloquent expression of the argument will be delivered with the passage of time itself.

For now, fwiw, I just totally ignore the idea that the Fed will do anything to address a bubble in the equity market. They might address a bubble elsewhere, but not with monetary policy, even there.

But leaving aside the Fed’s (boldly) presumed authority on this issue or the debate about whether they might act on it, what is the evidence that equities are even overvalued?

I approach this issue with some humility and trepidation because I have been arguing for the past couple years that equities look about fairly priced to deliver positive but subpar returns over the longer haul.  The effect of weaker growth prospects is at least fully offset within a market DDM by low Treasury real yields, and the low level of economic volatility seems to be the tie breaker favoring a higher multiple.  But all this says that they can stay full to deliver the low returns consistent with the slow growth and lack of case for a high “risk” premium.

In the event, I should have gone with Antonio Fatas who said, nope, they are sccreaming cheap!  Leaving aside whether he was/is right on the merits, my wealth would be higher had I assumed he was!

But just because I have been wrong for two years does not mean I should change my view. Having spend some (the minority) time on the sell side, I am made of sterner stuff than just that!  As I see it, there is not really much reason to change my take.   Wake me up when bond yields are about to spike or a recession is imminent. Even then, could probably only get flat.  You need to be smarter than I am to pay what seems to be the premium.

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This is hokey, crude and low-conviction stuff. Whether the earnings yield should be “adjusted” for potential growth is an ugly issue that I have not resolved. Separately, please don’t interpret the blue line being above the black line in the last chart as evidence that equities are cheap. Maybe they are, but that is not the point of the chart — or my view.

They look unexciting but not overvalued, certainly not demonstrably enough for the Fed to act. And the reasons for this have not changed either. So here is just an update of the chart, reflecting some new data and a sell-side like decision in this case to show you just the half century over which my very crude proxy has behaved roughly as one might expect.  (Prior to the mid-1960s, you cannot link the estimated premium to economic vol, even roughly.)

[1] I need to get short because stocks are 1 ½ sigmas above avarage valuation. And from here they have historically generated… … um  let me look that up … … oh +4% real over time?