Potential Dangers in the Stock Market
On Wednesday, May 6, Federal Reserve Chair Yellen spoke at the Finance and Society conference in Washington, D.C. Also at the event was the International Monetary Fund (IMF) Managing Director Christine Lagarde.
In response to a question from Lagarde, Yellen said, “I would highlight that equity market valuations at this point generally are quite high […] there are potential dangers there.” (Source: Reuters, May 6, 2015.)
Moreover, Yellen said the gap between high-quality bonds and high-yield low-quality bonds is getting smaller, indicating a “reach-for-yield type of behavior.”
In her speech, Yellen also criticized the “distorted incentives” in the financial industry. She said that prior to the Great Recession, the financial sector encouraged households to take on mortgages “they neither understood nor could afford” and facilitated a bubble in the housing market. (Source: Federal Reserve, May 6, 2015.)
The Fed chairwoman’s remarks had some impact on the stock market. During her speech, the S&P 500 index fell 0.5%, while the Dow Jones Industrial Average fell 0.6%.
Central bankers have been careful with words that might spook the stock market. The most famous example is the term “irrational exuberance,” coined by then Federal Reserve Chairman, Alan Greenspan. His comment on December 5, 1996 sent the Dow plummeting 166 points.
Stock Market: Overvalued
One thing that fuels high stock prices is the low interest rate. When there is no other alternative, investors will rush to the stock market and eventually a bubble will build up.
Indeed, the stock market is overvalued. According to the CAPE ratio, the S&P 500 is overvalued by 70%. The only times the ratio has been above this level were in 1929 and 1999. Netgear Inc. (NASDAQ/NTGR), currently trading at $30.24, has a price-to-earnings ratio (P/E ratio) of 1502. Cogent Communications Holdings, Inc. (NASDAQ/CCOI) has a P/E ratio of 1763. And there are many more companies in the U.S. stock market with crazy valuations. A lot of companies are also buying back their shares to boost their earnings before the earnings report.
Stock prices need to reflect the earnings of the companies that trade on the market. With corporate earnings growth and revenue growth both contracting in the first quarter of 2015, and the economy weakening (as evidenced by dismal 0.2% GDP first-quarter growth), we could be nearing the end of the rally in stock prices that started in 2009.