Federal Bubble Blindness

 |  Includes: SPY
by: Acting Man

Things Not Obvious to San Francisco Fed Chief

Marketwatch reports that San Francisco Fed president John Williams (a noted dove if memory serves) doesn't see the stock market as particularly overvalued at present, even though it sports a CAPE (cyclically adjusted P/E) or “Shiller P/E” of approximately 24, which is in the upper decile of all historical observations – we refer you to a recent article by Doug Short on market valuation in this context.

John Williams is correct insofar as we have not quite yet reached the crazy CAPE valuations of the 1929 peak or the tech mania peak. Of course those are not his yardsticks. With regard to valuations he says:

“With respect to stocks being near-record highs and the Fed’s hand in that, Williams said the media talks more about stock prices than the Fed does. Williams said policy makers take economic data, household wealth and money in the stock market into account, but they are not drivers of monetary policy.

“If you look at the valuation of stocks today compared to earnings and dividends and relative to historical averages, it’s not obvious that the stock market is overvalued. In fact a lot of models will tell you that it’s undervalued given how strong profits have been.”

(emphasis added)

Which "models" might he be referring to? We hope not the so-called "Fed model", a favorite tool of bubble spin doctors, which has been thoroughly debunked by John Hussman on several occasions (see e.g. here for an excellent overview).

When it comes to the S&P's dividend yield, one doesn't really need a "model" to judge where we stand. A functioning pair of eyes will do just fine:

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SPX dividend yield since 1926. Note that the level of administered interest rates and t-note yields has for the better part of market history proved irrelevant for dividend yields. Thus the "Fed model" must not only be viewed skeptically with respect to price/earnings ratios, but also with respect to dividend yields. Since the beginning of the late 90s bubble, yields have remained at paltry levels.

We hasten to add that such valuation data tell us nothing about how far the market's uptrend might still stretch – they merely tell us something about long term market risk (highly unfavorable to today's buyers). Regarding the short term, one must keep in mind that the current monetary environment remains quite loose, to put it mildly. However, as we have pointed out on several previous occasions, other warning signs have been accumulating for several months already and the U.S. true money supply growth rate has begun to decline in spite of heavy "QE" lifting by the Fed.

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The SPX (white line), the SPX earnings yield (yellow line), 5 year "inflation break-even" (cyan line), and a combined earnings yield/inflation breakeven line (green) – earnings yield and prices are drifting ever farther apart.


Sentimentrader's "smart versus dumb money confidence" indicator – this suggests that there should at least be a correction quite soon.


Fed members have never recognized a bubble in real time. Why should it be different this time? Caveat emptor.

Charts by: Decisionpoint, Sentimentrader, Bloomberg