It's Not a Bubble
Is the stock market a bubble? Many think it is, yet Ms. Yellen clearly doesn't based on traditional valuation measures like price-to-earnings ratios and the equity risk premium.
How do we know? She said as much at her confirmation hearing in November. Moreover, given a chance to clarify her position during her seminannual testimony before the House Financial Services Committee on February 11, she reiterated that stocks, generally speaking, are not exhibiting bubble-like activity.
The "generally speaking" portion of her remark is definitively important in terms of her position.
There are certainly bubbles within the stock market, which we will examine in a bit, but in considering the broader stock market, it is true that valuation measures are nowhere near the extremes they were at during the dot-com bubble days.
They are pushing some of the elevated levels seen near the 2007 stock market peak, but it was residential real estate that was in a bubble then, not the stock market. The stock market in 2007 had a full valuation historically speaking, leaving it vulnerable to increased selling interest in the event something bad happened. Well, as we all know, something bad happened.
Note: the gap in the P/E chart omits the huge skew created by the losses incurred by the financials during the 2008-2009 crisis
On the Margin
We suspect Ms. Yellen is looking at data -- and charts like the ones above created from that data -- to support her position. Objectively, they clearly show that it's a stretch to call things a bubble today.
Even the Shiller P/E ratio, which is based on average inflation-adjusted earnings from the previous 10 years and is seen by a number of people to be a more credible valuation gauge, isn't close to the dot-com bubble high of 43.8 seen in January 2000. Today it sits at 26.0. That isn't cheap relative to a mean of 16.5 and it is certainly bloated considering it stood at 27.2 in January 2007. Nevertheless, it isn't bubblicious.
Just because the stock market isn't in a bubble, however, doesn't mean it isn't out of whack.
The stock market today is out of whack because of the Fed's monetary policy. Interest rates at the zero bound are providing an incentive to reach for yield and, quite frankly, to speculate. Thus far, stock market participants have been rewarded handsomely for doing so and have been pushing the envelope in a certain respect doing so.
The latest data on the use of margin debt at the NYSE suggests as much. It climbed to a record $451.3 billion, or 2.64% of nominal GDP, in January 2014. In relation to GDP, margin debt is at its second-highest point in history, trailing only the dot-com bubble days when it hit 2.77% in March 2000. The surge in January pushed it past the June 2007 peak of 2.62%.
In past commentary discussing the rising use of margin debt, we hastened to add that it is not a negative in its own right since it can be regarded as a sign of increased confidence in the market outlook. The vulnerability sets in, though, when looking at margin account credit balances (total free credit minus total margin debt).
It is not unusual for this number to be below zero, which suggests negative trading net worth. In fact, the average over the last 10 years is -$13.4 bln. The latest data places margin account credit balances at -$159.4 bln or nearly double the deficit seen in June 2007. The message here is that there is a heightened risk of forced liquidation of stocks in the event something bad happens that forces an abrupt shift in sentiment.
Elements of Froth
The Federal Reserve released its latest Z.1 report on March 6. It is now officially known as the "Financial Accounts of the United States" report. The lead headline generated by that report is that household net worth has risen to a record-high of $80.7 trillion, up 14% from the year-ago period and up 17% from June 2007.
The huge decline in net worth seen during the financial crisis has been made up and then some thanks to both the recovery in housing and stock prices. There aren't many people complaining about that recovery, except the many millions of people who don't own a house and/or stocks.
We can see graphically again just how significant the recovery in stock prices has been looking at the Russell 3000. That average accounts for 98% of the investable US equity market. The market value of the Russell 3000 topped $21 trillion this past week or roughly $14 trillion more than the market value seen in March 2009.
There is a whole lot of paper wealth resting in the stock market. It has been a huge and impressive move; and today the market value of the Russell 3000 is 123.6% of nominal GDP, placing it above the July 2007 peak of 119.5%.
What can be extrapolated from the chart above is that stocks can remain in an overbought condition a lot longer than one might expect -- and perhaps even more so with interest rates at the zero bound and currently not expected to move from there for at least another year, if not two. However, the elements of froth in the stock market, broadly speaking, are building.
In her February 27 testimony before the Senate Banking Committee, Ms. Yellen did concede that some pockets of froth are catching the Fed's attention. She cited rising farmland prices and deteriorating underwriting standards for some loans as areas of concern, but stocks didn't get placed in the froth pocket.
We noted above why the Fed chair would think as much, yet there are clearly pockets of froth -- nay, bubbles -- in the stock market.
The froth in the biotech space is noteworthy. Consider the NYSE Arca Biotech Index (BTK), which soared 151% in 2013. At its high this past Thursday, it was up 17% from its low on February 5 and up 25% for the year. Several companies within the biotech index aren't even making money.
And how about the pot stocks? Boy, have they been on a high. Now, there's a bubble with several stocks going from the pink sheets to the silk sheets.
For example, Advanced Cannabis Solutions (CANN) had a market capitalization of roughly $21 mln a year ago based on a stock price of $1.60. There was literally no trading volume in the stock on March 7, 2013. The stock crossed at $64.64 at its high this past Wednesday on volume of 1.2 mln shares. Its market cap topped $800 mln. Oh, by the way, CANN was trading at $12.05 as recently as February 11 when Ms. Yellen was giving her testimony before the House Financial Services Committee.
The fuel cell stocks, meanwhile, have also been holed up in the froth pocket of late thanks to Tesla (also a frothy stock), which said it is planning to build a Gigafactory in a bid to drive down lithium ion battery costs. Ballard Power (BLDP), which began the year trading at a $1.52, crossed at $5.89 on Wednesday. Fuel Cell Energy (FCEL), which closed 2013 at $1.41, hit $3.40 on Wednesday. Neither company is profitable.
Lest we forget, Coupons.com (COUP) made its debut on Friday, opening 70% above its IPO price of $16.00. It had doubled in price as of this writing.
There was some sweet irony in that successful IPO. Coupons.com, which isn't yet profitable, provides digital coupons in the US (not exactly a deep moat model), generating some bargain-hunting opportunities for its customers. Its huge gain ratcheted the company's market cap up to $2.2 billion, resulting in a rich price-to-sales ratio of 13.2x FY13 revenue, which is higher than its profitable competitor RetailMeNot (SALE).
I could go on, but I trust readers get the point that, even if there is not bubble-like activity "broadly speaking," one doesn't have to look too hard to see it less broadly speaking.
What It All Means
We're not saying the stock market can't go higher still. It can, because the market has a strong attachment to the Fed's easy-money policy.
The investment risks are building, however, with the increasing signs of froth in the stock market. Nothing can be taken for granted even though the stock market is trading with that air of invincibility again.
The first rule of investment is to manage one's risk. That means different things for different people and it will factor more prominently when diving into the pockets of froth.
Ms. Yellen isn't calling a bubble and she is right with her general interpretation of matters. I'm sorry to say, however, that there is some craziness taking place in the stock market from which the Fed cannot disavow itself. It has created the opening for specific pockets of froth that risk inviting froth more broadly speaking.
The stock market isn't a bubble, but its valuation is full and there are signs in front of the Fed that make it clear the stock market is vulnerable to an unsettling setback if something bad happens or the Fed kills its own credibility.
--Patrick J. O'Hare, Briefing.com