Rational Exuberance?

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? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.

Alan Greenspan, The Challenge Of Central Banking in a Democratic Society

More generally, valuations for the equity market as a whole and other broad categories of assets, such as residential real estate, remain within historical norms.

Janet Yellen, Prepared statement following last week’s FOMC meeting

The only reason Janet Yellen’s statement that equity market valuations “remain within historical norms” is because Alan Greenspan went on to ignore his own advice. Market valuations at the time of Greenspan’s speech were, by various measures, almost identical to today. Indeed, by several measures, the market is more highly valued today than in 1996. Shiller P/E, market cap to GDP and Tobin’s Q are at levels today that exceed those of the mid 90s. Price to sales ratios are roughly the same.

Although it is easy to dismiss Greenspan’s irrational exuberance comment as mere speculative musing – as many did at the time – it is rare for a Fed chief to say something for public consumption without considering the market response. Greenspan knew that commenting on stock prices in any context would affect the market and one can only presume that he got the response he wanted, if only briefly. Likewise, today with Janet Yellen’s comments. The Fed has spent the last 5 years pumping up asset prices chasing a presumed but so far elusive wealth effect. To date, it appears to me that the only wealth effect has been an inflation of political rhetoric, but hope springs eternal at the Fed. Assuming Yellen buys into the portfolio balance channel effect laid out by Ben Bernanke –  and she sure seems to – she must continue to reassure risk takers that the Fed is not considering any action that would derail the gravy train.

Certainly, Yellen is correct that today’s market falls within historical norms if one includes the period after Greenspan’s speech until the ultimate peak in early 2000. Bulls might be comforted that stocks continued to rise for a full four years after the irrational exuberance speech before reaching those all time high valuations that are now included in the history Yellen cites. They might also note though that the subsequent bear market took the S&P back almost exactly to the levels that prevailed at the time of Greenspan’s speech. If those 2000 valuations are the point at which Yellen & Co. might consider taking some action it should be noted that several valuation measures are approaching those previous peaks. So, while history does allow some further expansion of valuations before breaking new ground, the space between here and there is shrinking rapidly.

Yellen and the Fed also updated their economic outlook last week, conceding that, after a very weak first quarter, their previous estimates for the year are unlikely to be achieved. Don’t be surprised if they have to further downgrade their outlook again as that 1st quarter GDP number is likely to be revised lower yet again. The Census Bureau recently released their services report showing that healthcare spending was considerably weaker than originally estimated in the GDP report. The final revision of 1st quarter GDP seems likely to carry a -2 handle. Only a very strong rebound from that weather distorted quarter would allow the economy to achieve even the Fed’s latest, lower estimate for the full year.

And the recent economic data – at least some of it – does appear to be showing a rebound in the spring. The regional Fed surveys have been almost uniformly strong and the jobs market, as measured by jobless claims, appears steady if not spectacular. The rebound certainly isn’t uniform though with several economic metrics showing little improvement. Consumption continues to be affected by a lack of real income growth and those incomes are being negatively affected by a recent upward trend in inflation. I do think though that inflation is self limiting to some degree. Absent a rise in wages – and workers would seem to have little bargaining power at present – a rise in prices is likely to be met with a concurrent drop in consumption volume.

Investment also remains weak, whether residential or non. The new home market spring rebound appears to have been short lived with starts coming in below expectations last week while permits fell below current starts. That would not appear to show much confidence on the part of builders. Real estate in general is being impacted – and will for many years in my opinion – by the lack of first time buyers. A good part of the problem there is the debt load taken on for college which is keeping younger potential buyers not only out of the market but in Mom’s basement. Corporate investment has been somewhat better but the mix is not encouraging with 30% of Capex the last few years going to the oil and gas industry. It can’t be good news that nearly 1/3 of investment is going to poking holes in the ground. Another large component of that spending has been in the transportation industry and while some of that is for autos, a big part of it is in aircraft, a very long lived asset. And a not inconsiderable portion has been in rail cars for the purpose of transporting crude oil fracked in areas where pipelines don’t extend.

Part of the lack of investment can also be explained by the frenzy in stock buybacks which approached the previous record (set in 2007 by the way) in the first quarter of 2014. Total buybacks for S&P 500 companies were up 59.3% to $159.3 billion. Add in dividends and the total returned to shareholders was 93% of S&P 500 profits in the quarter. I think that is the definition of unsustainable and unlikely to continue, at least at that pace. Of course, this buyback and dividend activity was not funded directly from profits as corporate bond issuance totaled $374 billion in the first quarter. One does wonder though how much more corporate balance sheets can be leveraged in pursuit of higher stock prices and executive bonuses.

In addition to the buyback activity, we are seeing in the markets other activities that have in the past been associated with valuation tops. M&A activity is approaching a frenzy with another raft of deals reported last week. Some of the deals I’ve seen seem to make little sense. Medtronic offered a nearly 30% premium to the current stock price to acquire Covidien. The rationale for the deal escapes me other than the obvious one of the combined company being incorporated in Ireland where tax rates are low. However, the two companies had similar effective tax rates so I’m not even sure that makes much sense. The two companies have little in common other than being involved in healthcare albeit in only superficially similar product lines. Both companies have similar low single digit sales growth rates. The deal does allow Medtronic a bit more flexibility with regard to its overseas cash holdings but that seem a thin reed on which to hang a $43 billion deal.

There are significant differences between today’s market and the one Greenspan seemed worried about in 1996. Most obvious is that in 1996 we were in the midst of an historic rise in productivity due to the revolution in communications. While there is still considerable innovation in today’s economy, it is hard to see a similar step change in productivity on the horizon. In many ways, the dot com boom was more rational than today’s rise in stock prices. At least back then the rise was predicated on optimism about the real economy. Today’s optimism is based on a belief in the Fed’s omnipotence, that Yellen & Co. will eventually be able to produce the expansion they’ve been promising for so long. Now that’s irrational.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@alhambrapartners.com or   786-249-3773. You can also book an appointment using our contact form.

4 Responses to Rational Exuberance?
  1. Ken Hartley, CFA
    June 23, 2014 at 6:56 am

    You seem to reject the notion that capital should seek its best return.
    Oil and gas and the ancillary services associated with it are laying the
    ground work for future lower production cost. Would you rather see
    the cap ex go to more building of vacant CRE, or maybe some cost
    inefficient alt energy projects?

    While I agree that some issues are cause for concern in today’s
    financial markets, I believe it is cause and effect from the misplaced
    hand of gov’t regulation and largess imposed on businesses at
    multiple levels.

    Reply
    • Joseph Y. Calhoun
      June 23, 2014 at 8:50 am

      Ken,

      I think you make my point when you mention real estate. Much of the capex in oil and gas is going to fund fracking to extract oil with a high marginal cost. And a good deal of that is being funded via debt just as the previous real estate boom. It is the low cost of capital that is driving the investment. Higher interest rates or lower oil prices would make most of this drilling unprofitable. Since either of those variables could change at any moment, the drilling activity would appear unsustainable, just as happened with the real estate boom.

      We’ve already seen a large number of companies writing down their shale gas assets (BP, RD Shell, Chesapeake, Encana, BHP to name a few) after prices collapsed due to the excess supply produced by fracking.

      I don’t reject the notion that capital should seek its best return. I do reject the notion that distorting the cost of that capital has no consequences.

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