Yellen About Valuations

"Some broad equity price indexes have increased to all-time highs in nominal terms since the end of 2013. However, valuation measures for the overall market in early July were generally at levels not far above their historical averages, suggesting that, in aggregate, investors are not excessively optimistic regarding equities. Nevertheless, valuation metrics in some sectors do appear substantially stretched-particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year." ^[i]

So read the Fed's July Monetary Policy Report, which accompanied Fed Chairwoman Janet Yellen's testimony to the Senate Banking Committee on Tuesday. For those unfamiliar with Fed speak, allow us to translate: "Sure, market-wide valuations aren't out of whack, but there are some signs of froth." While the punditryseized on the "it's overvalued!" angle, to us, Yellen's testimony says more about her methods of market analysis and forecasting than it does about the actual state of the market-which, in our view, remains far from frothy.

One wonders if this report was intended for release in April or May, not July. That "notable downturn" Yellen mentioned is pretty much past-tense. The MSCI World Biotechnology Subindex had a -17.4% correction from February 24 through April 11, but it was back at new highs by July 3 (it's down a shade since).^[ii] Social media is a teensy slice of the MSCI World Internet Software & Services Subindex, which lost 16.8% from March 5 through May 8, before bouncing back 12.4%, putting the subsector 6.4% below its prior peak.^[iii] So it largely goes without saying that valuations are up despite the downturn-prices corrected, then investors decided to bid them back up based on their perception of the companies' potential. Whether that's warranted or not is a topic for another day, but it's just sort of how investors behave. It's a post-correction rebound-totally normal. If anything, one can argue that correction shook out some of the euphoria that might have existed in these industries earlier this year, but we digress.

More broadly, making a big deal out of high valuations in two subsectors seems just a tad myopic-social media and biotechnology are decidedly not the entire economy, and they are a sliver of the global market. Biotech, part of the Health Care sector, is 1.5% of the MSCI World Index by market cap.^[iv] Internet Software and Services are 1.9% of the MSCI World's market cap, and social media is a fraction of that category.^[v] There is exactly one-one!-social media firm in the entire S&P 500.^[vi] Simply, you can't cherry pick less than 4% of the global market and call it evidence of unchecked sentiment-not when the other 96-plus% looks pretty normal for a maturing bull.

Even if it didn't, you can't base a "bubble" argument on valuations alone. By that logic, one might have argued stocks were in a bubble in March 2009-the beginning of this bull market. Sure, P/Es today are above their long-term average, but there is no evidence high P/E markets are inherently risky. It's normal for valuations to expand as a bull market matures. It's a sign of improving sentiment-investors naturally become more willing to pay more for a slice of future earnings. At some point, that mounting optimism turns to euphoria, but there is no "aha!" level of valuations that clearly indicate froth. P/Es peaked just above the long-term average before the 1990 bear; they were far higher at the Tech Bubble's peak. Valuations' trajectory over a bull's life can show how sentiment evolves, but there isn't a magic number you can point to as an endpoint-you need more evidence than just valuations to determine whether sentiment is out of whack.

While Yellen's assessment isn't actionable, it still has its uses: It gave us another example of Yellen's cautious, noncommittal approach to market and economic forecasting. Calling out potential froth in small industries folks have been warning about for months isn't Alan Greenspan warning of "irrational exuberance" in 1996-it's caution. This isn't an isolated example. Revisit the Fed transcripts from 2008, and you'll see her forecasts were based on past data, extrapolating very recent trends forward with a lot of hedging. She shied away from making genuinely forward-looking statements based on expectations for the future and actual turning points. She has done the same thing since she became Fed head, peppering tepid forecasts with ifs, thens and woulds. All this suggests Yellen knows she isn't a great forecaster. Which is fine. Preferable, even! It makes her less prone to act quickly and rashly, more prone to gradualism. That's a positive.

As is the overall backdrop for stocks right now. Economic and political fundamentals are strong, and despite the claims of Yellen andothers, sentiment isn't sky-high. If markets were really euphoric, headlines would have laughed Yellen out of the building for suggesting stocks were overvalued. That the media was more than willing to lend her some credibility suggests sentiment has quite a ways to improve and this bull room to run.