What The Fed Means When It Says Stocks Are Expensive

As I mentioned, the Fed said in its Minutes that valuations were ‘quite high.’ CNBC decided to do an analysis of how stocks performed one year after the Fed has said stocks were expensive because the Fed rarely comments on valuations. As you can see in the chart below, the Fed has commented on how expensive valuations were six times since 1996. If you look at the Shiller PE, the stock market has spent almost all the time from December 1996 until now above the median PE which is about 16. The only time it fell below the median PE was the depths of the 2008 bear market. Therefore, the Fed has been correct in its analysis.

The perspective on valuations should not be looked at in terms of twelve-month performance since valuations effect long term performance, not short term performance. Even with the analysis looking at too short of a period, the Fed’s statements were accurate as you can see in the chart below. The Dow was down 5 out of the 6 times the Fed said stocks were expensive and the Nasdaq was down an average 16.83% (because of the tech bubble burst).

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The Fed’s analysis isn’t like a market forecaster would make because they set policy which effects the market. The Fed is also biased to the positive side because it doesn’t want to spook the market. The Fed hasn’t predicted any of the past few recessions in advance because it thinks predicting one would cause one. The Fed will only comment on valuations if they get way out of hand.

A great analogy to this situation is when Reed Hastings, the CEO of Netflix, commented on the high valuation Netflix stock had gotten to. As the CEO of the company, Reed doesn’t want to tell investors not to buy his stock. However, Netflix stock had risen to such insane valuations he felt the need to try to squash the bubble before it got bigger. A spiking and crashing stock price hurts the firm. The difference between Reed Hastings and the Fed is that the Fed has caused stock market bubbles through setting artificially low interest rates (below the Taylor Rule) while Reed Hastings didn’t cause Netflix to rise so quickly. In fact, the Fed also played a part if why Netflix’s stock has risen fast because of its QE and low interest rate policy.

I have established that objectively stocks are overvalued and that the Fed is far from a third-party prognosticator when analyzing the market. What I will look at now is if the Fed saying stocks are overvalued signals what it will do to interest rates. Before looking at the policy results, I would expect to see interest rates rising in the next twelve-months after it said stocks are expensive. Raising rates is supposed to stop the economy from overheating.

The first time it said stocks were overvalued in this period was December 1996. In December 1996, the Fed funds rate was 5.29%. In December 1997, the Fed funds rate was 5.50% which is in tune with what I expected.

In March 2000, the Fed said stocks were expensive and the Fed funds rate was 5.85%. Twelve-months later the Fed funds rate was 5.31%. The Fed funds rate was raised after March 2000, but it ended up being lower because it started cutting rates in December 2000 as the next recession was nearing.

December 2001 was the third time it said stocks were expensive. This did not signal a future rate hike as rates fell from 1.82% to 1.24%. December 2001 was after most of the fall in the Nasdaq had occurred. December 2001 was a tough time to analyze the stock market because of the terrorist attack which occurred in September 2001. The Fed was worried about a rebound in earnings not happening and the effects another terrorist attack would have.

In January 2004, the Fed funds rate was 1.00% and twelve months later it was 2.28%. These rate hikes were part of the stamp out of the housing bubble. It turned out that houses in Nevada, California, and Florida were more overvalued than stocks were at the time. If the Fed understood the ramifications of its actions, it wouldn’t have lowered rates that low in conjunction with the government pushing people to buy a house. This time the government pushed people to take out loans for college and then the Fed raised rates. The people who took out adjustable rate mortgages and college loans feel the brunt of rate hikes.

The Fed kept rates flat in the twelve months after it said stocks were expensive in September 2014. The effective federal funds rate increased from 0.09% to 0.14%. You may wonder why a college student would make such a silly decision to take out an adjustable rate loan when interest rates can only go up. The reason is likely a combination of ignorance and penny pinching. Adjustable rate loans have lower rates in the short-term. Since interest rates have been low for a long time, one may foolishly assume they will remain low for the duration of the loan (15 years typically).

The final time in this period when the Fed said stocks were expensive was in 2015 when it raised the effective Fed funds rate from 0.12% to 0.37%. The Fed has been warning about stocks being expensive for three years. While this is accurate, it’s interesting how the Fed issued less warnings in the late 1990s when stocks were more expensive.

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Conclusion

On average, the Fed raised rates 0.11% in the twelve months after it said stocks were expensive. This small increase is slightly misleading because the Fed raised and then cut them in 2000. Taking this raise into account, the Fed raised rates 5 out of the 6 times after it said stocks were expensive. This gives us a hint that the Fed will likely raise rates in the next twelve months. The Fed can easily knock down stocks if it decides stocks are too expensive and need to fall to avoid the bubble from getting bigger and having a worse bust. Personally, I think it’s already too late as the Shiller PE is at 28.96.