This past Wednesday the Chair of the Federal Reserve, Janet Yellen, beefed up the debate between investors and economists, saying that “equity market valuations at this point are quite high” and that long-term yields could rise once the Fed starts hiking rates. Her remarks came before an audience at the International Monetary Fund in Washington, in conversation with its Managing Director Christine Lagarde. As we could easily imagine, stock markets around the world initially reacted negatively to her statements, but as of Friday morning have fully recovered.
Although it’s not unusual to receive investment tips from the head of the Federal Reserve every now and then, I do question how useful their insights really are. For example, in 1996 then Chairman Alan Greenspan famously diagnosed the stock market as suffering from “irrational exuberance,” making a case that stock valuations were stretching beyond economic means. The next day stocks in the US promptly dropped 2.35%. However, three years later the US stock market was up 89%. From July 2005 to July 2007 then Chairman Ben Bernanke appeared numerous times before congress and the media (watch them all here) to appease talk of a real estate bubble. We don’t need reminding how that turned out.
I don’t mean to suggest that investors should be able to rely on the Chair of the Federal Reserve to have some special ability to predict markets. Even with access to private information, no one can reliably and repeatedly predict such complex systems. Nor should investors believe that valuation is a useful tool to predict short-run performance. As I wrote last month in “Not all heroes wear CAPEs”, most of the time equities are reasonably priced and reflect long term expectations about interest rates and earnings.
However what I do mean to suggest is that the Chair of the Federal Reserve should stick to managing short-term interest rates and leave investing to investors. Although the Fed’s efforts around moral suasion are surely coming from a noble place, they repeatedly miss the mark in practice and result in misinformation. In no way have their efforts to discuss market valuation achieved their stated goal of maintaining stability of the financial system. Financial stability is not about trying to prevent the inevitable booms and busts of human nature and market cycles, but about creating a system that can safely deal with those shocks.
On another note, I’ve read that some investors have pointed to Yellen’s comments suggesting that rising long-term interest rates would cause a new recession. Acknowledging that recessions are notorious difficult to predict, history shows rising interest rates on their own do not cause recessions. Instead, data show the best leading indicator of recession is when short term interest rates are equal to or higher than long term interest rates. In real life, that means it would cost more to borrow money overnight than it would to borrow it for 30 years. Sounds strange, doesn’t it? This pattern has taken place before the start of every US recession for the last 50 years with a perfect 7 out of 7 record, usually signalling 12 months ahead. With short term US rates today at 0.01% and long term rates at 2.90% it looks like we have a long way to go before another round of irrational exuberance catches up.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.