Fed by the Fed: A New Bubble Grows on Wall St.
17 Pages Posted: 5 Aug 2014
Date Written: August 4, 2014
With bond yields at all-time lows after the Fed’s quantitative easing drove real interest rates to the zero-bound and even briefly below it, investors have allocated ever more money to equities. Lacking alternatives, the stock market has grown flush from yield-hungry buyers.
But now the mood is changing. The economy is looking up, “recovering,” according to some selective data-pickers. And the Fed and other central banks have signaled their intent to end their QE programs. Investors are right to wonder how this shift in central bank policy, and the introduction of rising policy rates, will affect the lofty valuation levels of the US stock market.
Some observers see the good times continuing for equities. They argue that accelerating growth expectations will more than compensate for the improving valuations of non-equity investments, keeping equities ahead of the pack. Stocks, they proclaim, can only go up. Think again, we say, after we examined three scenarios of projected valuation levels, share prices, growth expectations and the levels of compensation investors demand for taking on equity risk.
We present our analysis in this Critical Perspectives report. We conclude that further stock market upside would demand risk aversion among investors to recede to levels last seen in the booming late 1990s. After the pain of the past six years, we think it unlikely that such euphoria can be revived. In fact, applying our long-term growth expectations to normal levels of risk appetite exposes a substantial downside potential for US equities of more than 40%. We acknowledge that markets often over- or under-shoot fair value and that a case can be made for even more lofty valuation levels. We simply do not think such a construct is sustainable, as we shall explain in this report.
Keywords: Shiller PE, stock market valuation, US equities, stock market bubble
JEL Classification: G11, G12, G15, G17
Suggested Citation: Suggested Citation