Yellen and the Markets’ Irrational Exuberance

The recent comments Janet Yellen about the high valuation of equities may have partly contributed to the cool down in the stock market today. But is the market experiencing irrational exuberance? Are equities overvalued?

Yellen said today that “I would highlight that equity market valuations at this point generally are quite high” and this comment was highly quoted and stir up, well, maybe a bit, the markets – after all it’s earning season.

But are equities highly valued? To answer this question one must ask relative to what?

If you look at the S&P500, you will see that it’s at an all time high and peak it reached back in 2007 of over 1,500 the index passed back in early 2013. So it’s high relative to itself. How about its peers? Relative to the STOXX50 the S&P500 rose by 75% in the past five years while the STOXX50 by only 7%. Conversely, the Nikkei 225 performed the same as the S&P500. But this could also be because the Japanese stock market is also in a state of overvaluation.

Let me cut to the chase, I think that we should consider two things: The interest rates in the U.S. and aboard. Currently long term yields are very low and, as you can see below, they have actually come down in the past year. This trend occurred even though interest rates should start to come up in the U.S. once the FOMC raises rates.

yields and snp500

Source: Google finance and U.S Department of Treasury

So, as some analysts pointed out, it seems that the bonds markets could be overvalued and could be, in part, driving higher the price of equities. Also, the ongoing poor performance of the equities in Europe accompanied by even lower bond yields of sovereign debt in Europe could be another driving force for the higher demand for U.S. equities.

But I do think that the market could be undervaluing the FOMC’s future plans to raise rates, which could bring down equities and increase bond yields. This scenario, however, won’t have a long lasting adverse affect. Because people need to invest and U.S. equities still offer a lucrative investment relative to Europe.

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