Wednesday, 27 February 2013

Do Not Rely on Bernanke's Stock Market Assessment

In today's congressional hearing, Bernanke "defended the central bank’s unprecedented asset purchases, saying they are supporting the expansion with little risk of inflation or asset-price bubbles" according to Bloomberg. Now, what's his view on the U.S. stock market?
Bernanke said U.S. stock prices don’t appear to be overvalued.
And how did he arrive at this conclusion?
“The so-called equity premium associated with stock prices is quite wide,” Bernanke said in response to a question. So, by that measure stocks “don’t appear overvalued given earnings and interest rates.” 
The "equity premium" generally refers to the excess return of stocks over the "risk-free rate", e.g. 10-year treasury yield, and can be estimated either ex-post or ex-ante. Here are two reasons why you should not rely on his answer if you are a U.S. stock market investor.

Firstly, the Fed wants to push asset prices up, including stock market prices, to "ease financial conditions". Bernanke will therefore pick any metric he can, or keep the statement as loose as possibly, to support further upward movements in the stock market.

Secondly, in the current artificially low interest rate environment the stock market is bound to appear not overvalued vs treasury yields even if valuation metrics such as the price-earnings ratio is high (e.g. at the current 10-year treasury yield of 2% the earnings yield of the stock market would be higher even if the price-earnings ratio was 49). But interest rates can change and they will not stay this low in perpetuity as they are artificially kept low by the Fed. And to properly value a stock or a stock market you need to discount future cash flows (in perpetuity). So, even if the current equity premium "is quite wide", which it is if you compare the current earnings yield with artificially low interest rates, the real question is: is it high enough? Is it high enough to cover for future increases in interest rates? This aspect is not covered in Bernanke's simple assessment above which is why his conclusion should be ignored and not relied upon.

What you should take away from his statement though is that, as stated above, he wants to push the stock market up further and he will do so through money printing which supports further expansion of broad money supply (which increases the amount of money in circulation, some of which will be allocated to the stock market) and suppresses yields. But this does not mean equity valuations are not becoming stretched. Based on earnings- and dividend yields stocks, as measured by the S&P 500 index, is becoming increasingly pricey. Additionally, as of Friday 25 February the Wilshire 5000 Total Market Full Cap Index and Wilshire 4500 Total Market Index are 13.2% and 23.5% higher than they were at the top of the bull market in 2007, even as the U.S. economy today is struggling with high unemployment and massive federal debt.

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