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  • Three Reasons The Federal Reserve Should Not Value Stock Sectors 12 comments
    Jul 20, 2014 8:43 PM | about stocks: IBB, SOCL

    When Janet Yellen and the Federal Reserve proclaimed that:

    valuation metrics in some sectors do appear substantially stretched-particularly those for smaller firms in the social media and biotechnology industries

    they caused a great deal of unwarranted hardship for American small business.

    Biotechnology and social media are two of the most important industries for the welfare of people and the future of the economy. Small companies go public to get funding, employ people, and grow. By singling out these two important sectors of the economy the Federal Reserve made it more difficult for these businesses to succeed.

    This action by the Federal Reserve is inappropriate for three main reasons: Authority, Capability, and Credibility.

    1) Authority - The Federal Reserve Does Not Have the Legal Authority to Take This Kind of Action

    The Federal Reserve is legally bound to its Dual Mandate of full employment and price stability. Calling out these two sectors for their supposed over-valuation is not defensible as part of the Federal Reserve's Dual Mandate.

    Employment was directly hurt by, not helped by, this action. The Federal Reserve worked directly against its legal mandate of full employment.

    Was there such a desirable benefit for price stability that this action does in fact fall under the Dual Mandate? The case for that is absurd.

    Neither sector is even related to traditional pricing models. Social media is almost entirely free of charge. This is the definition of stable consumer pricing.

    Biotechnology end-products have some of the most complex pricing mechanisms of any economic good -- involving private insurers, social programs, competing therapies, intellectual property, and laws at all levels.

    The idea that making it harder for small social media and biotechnology companies to get funding is some sort of a proper way for the Federal Reserve to influence price stability under its Dual Mandate is ludicrous.

    The Federal Reserve does not have the legal authority to take the action that it took.

    2) Capability - The Federal Reserve Cannot Value Sectors Better Than the Market

    The Federal Reserve has no ability to value any sector of the stock market better than the market itself does. We can see this in three main ways:

    A) No Magic Formula or Crystal Ball: If the Federal Reserve did have some sort of special formula or valuation strategy to "rightly" value the market, it would only make sense to share it with the public, so there would be no bubbles. They have no such formula.

    On what would these "right" special insights be based? History? Social media has no history.

    Small biotechnology companies are so different from one to another that any broad model for the sector is bound to be fraught with deficiencies. That alone should have kept the Federal Reserve from dealing a blow to the entire sector, most certainly including tomorrow's life saving technologies.

    These sectors are going to be very interesting in the future. The Federal Reserve does not have any better formulas or strategies than the market, and they have no crystal ball to know what will happen with these technologies.

    B) The Market is Self-Correcting: When sectors are "substantially stretched" firms can make a lot of money shorting these stocks, playing the role of keeping them properly valued. If the valuations are where they are, maybe they belong there. It is important to recognize who the people these firms employ are..

    C) The Private Sector Gets the Brightest Minds: People are much more motivated by money than by country, and the best employees do not go to the government, they go to the private sector. The government employees at the Federal Reserve making sector valuation calls are paid far less than the people that they are trying to outsmart.

    There is also the question of experience, of which there can be no question. Janet Yellen has no work experience in the private sector outside of a classroom, let alone work experience valuing stocks. She is a curious choice to tell the private sector what they are missing in their stock sector valuation analysis.

    The Federal Reserve has no ability to value any sector of the stock market better than the market itself does.

    3) Credibility - The Federal Reserve Has an Agency Problem

    When Janet Yellen and the officials at the Federal Reserve act outside the purview of the Dual Mandate, they become prone to an agency problem:

    Here the difficulty lies in assuring that the firm, as agent, does not behave opportunistically toward these various other principals

    Starting July 7, eight days before her testimony, small social media and biotechnology sectors sold off hard (see the etfs SOCL and IBB), kept selling off, and really started tumbling once Janet Yellen's remarks were finally revealed to rest of the world.

    (click to enlarge)

    As the Chair of the Board of Governors of the Federal Reserve System, Janet Yellen works with many people, each of whom has a staff of people, each with many important contacts. For practical purposes this means that a tip-off to friends of those involved is unavoidable 100% of the time.

    People close to Janet Yellen benefited by shorting the sectors she was about to censure, or by furnishing this information to others. Anytime the Chair provides such a lucrative opportunity like condemning small sectors of the market provides, and it's known by dozens of people weeks in advance, the same thing is fated to happen.

    The American people can anticipate the Chair already: my staff and I did nothing wrong "to best of my knowledge."

    The American people have no appetite for the "plausible deniability" that they already know surely awaits any inquiry into the obvious, assured tip-off.

    The Federal Reserve would only detract further from its flagging credibility if it tried to appear simultaneously credible and oblivious to this type of opportunistic behavior.

    Conclusion:

    Because of the lack of authority, capability, and credibility, Janet Yellen and the Federal Reserve should not try to substitute their stock sector valuations for the market's valuations.

    Now that they have done so it is important that they acknowledge the action was an error, and make a statement that further such action is inappropriate.

    You can sign the petition here.

    Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

    Themes: market-outlook Stocks: IBB, SOCL
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Comments (12)
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  • mark woods
    , contributor
    Comments (170) | Send Message
     
    Joe, you make a textbook case. I can almost hear the voice of Jack Webb on Dragnet making an unarguable observation. It's almost a shame you have to waste time on something this transparently wrong but as Jeff observed, "Nothing surprises me anymore with this administration."

     

    Really disappointing.
    20 Jul, 09:33 PM Reply Like
  • Joe Springer
    , contributor
    Comments (2303) | Send Message
     
    Author’s reply » Thank you Mark, and thank you for signing.
    20 Jul, 09:40 PM Reply Like
  • goinglong2020
    , contributor
    Comments (140) | Send Message
     
    Excellent argument Joe. I hope the petition makes some sort of positive impact.
    20 Jul, 10:17 PM Reply Like
  • Joe Springer
    , contributor
    Comments (2303) | Send Message
     
    Author’s reply » Thank you goinglong2020, me too!
    20 Jul, 10:24 PM Reply Like
  • WideMoat Capital
    , contributor
    Comments (45) | Send Message
     
    Thank you Joe, you make an excellent argument.
    20 Jul, 11:01 PM Reply Like
  • Joe Springer
    , contributor
    Comments (2303) | Send Message
     
    Author’s reply » Most welcome WideMoat, thank you, please pass along to anyone you think might sign.
    20 Jul, 11:03 PM Reply Like
  • harrik
    , contributor
    Comments (36) | Send Message
     
    Joe, I am one of your followers, since I usually find your articles interesting and informative. Your basic premise in this article misses one important point.

     

    If Yellen's opinion about stock valuation is not credible, then the market should discount her opinion and move on. If this is one of those mistakes of the market, then this is a buying oportunity. Yellen has a voice by virtue of her unique position. That doesn't mean that we have to believe everything she says.
    21 Jul, 06:50 AM Reply Like
  • Joe Springer
    , contributor
    Comments (2303) | Send Message
     
    Author’s reply » Thank you for sharing that harrik, I know this is a departure from fun and research, I really feel strongly about this.

     

    I understand your point:

     

    "If Yellen's opinion about stock valuation is not credible, then the market should discount her opinion and move on."

     

    And in the long run I agree, but in the long run we're all dead and short-term "don't fight the Fed" is powerful.

     

    Businesses have it harder today, and shareholders are lighter in the wallet today, and I don't think the Fed has the right, or know-how, or moral-perfection to do such things.
    21 Jul, 09:00 AM Reply Like
  • eyedoc08225
    , contributor
    Comments (28) | Send Message
     
    A very cogent argument. Well played sir.
    21 Jul, 10:37 AM Reply Like
  • Joe Springer
    , contributor
    Comments (2303) | Send Message
     
    Author’s reply » Thank you eyedoc!
    21 Jul, 10:47 AM Reply Like
  • Bernerx3
    , contributor
    Comments (2) | Send Message
     
    Joe, your analysis is spot on why Janet Yellen & company were out of line and did a great disservice, I'm with you on this one. Great work and I hope they feel the heat!
    21 Jul, 05:07 PM Reply Like
  • Joe Springer
    , contributor
    Comments (2303) | Send Message
     
    Author’s reply » Thank you Bernerx3, I'm hoping that further such statements will be deemed an unhelpful headache for themselves.

     

    The Treasury Secretary basically publicly said he disagreed, we can be a small part of why it is too much of a pain to throw select sectors under the bus.
    21 Jul, 05:13 PM Reply Like
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