Equity markets rallied after hearing the soothing words from Janet Yellen in her post FOMC press conference on Wednesday. Despite the committee raising their estimate of rate increases over the next two years and downgrading growth estimates for this year, Janet Yellen soothed the markets by dismissing all and any concerns. She wants us to believe we are in a Goldilocks environment and equity investors seem happy to buy into that narrative for the time being.
We believe that, in the longer term, the likelihood of a policy error is extremely high especially when Yellen dismisses the recent rise in the rate of inflation as “noise”. It’s not just the recent rise in consumer prices that the Fed continues to ignore. Just as in the Greenspan and Bernanke eras, policy makers are ignoring asset price inflation and the risks that this brings to financial stability in the future. It may seem remarkable that they have not learned from previous cycles, but the Fed is repeating the same mistakes as it did in the late 1990s and the mid 2000’s.
Why does this matter? The historical record illustrates that financial instability can impact the real economy and so we find it extremely imprudent that the Fed sets policy purely on employment and inflation metrics without paying attention to potential bubbles forming. The Fed explains away their forecasting errors (all their forecasts have been badly wrong since the crisis as well as before) and tell us that it is simply not possible to analyse in real time whether asset prices are overvalued or not. Yellen and her predecessors are either ignorant of history and robust analysis that can value financial markets over the long term or are being deceitful.
The chart below is extremely simple (we use others as well which are perhaps more mainstream). It shows the market value of non-financial companies relative to GDP (blue line) and then the subsequent 10 year annualised total nominal returns (red line). The red line is inverted. The R-squared here is strikingly high at over 80%, and currently indicates that non financial stocks will generate negative returns over the next 10 years.
The Fed has allowed markets to become egregiously overvalued which almost guarantees a policy error. Either they continue to be too easy with policy and the asset price bubble gets bigger before it pops (with negative feedback loops impacting the real economy) or they try and get ahead of the curve and risk popping the bubble and hope that the economy will survive unscathed.
Our money is on the too easy for too long outcome. What we do not know is when the bubble will pop. All we can say with certainty is that the market is overvalued and likely to disappoint in the longer term and that we view the current potential reward versus risk profile as truly awful.