Just Letting Some Air Out of the Bubble?


For months – and in some cases years – a boisterous group of market analysts has contended that stock markets are way overvalued, artificially lifted by years of Federal Reserve stimulus in the wake of the 2008 financial crisis.

Even Fed Chair Janet Yellen has not once, but twice alluded to elevated stock market valuations, first suggesting in July 2014 during Congressional testimony that biotech stocks were possibly nearing bubble territory.

She reiterated her point on valuations in May this year at a conference in Washington, D.C.

“I would highlight that equity market valuations at this point generally are quite high. Now they’re not so high when you compare the returns on equities to the returns on safe assets like bonds which are also very low, but there are potential dangers there.”

Now with the turbulence in China’s financial markets causing volatility in U.S. stocks not seen since late 2008, some analysts point out that the U.S. economy remains mostly sound and that U.S. stocks had room to fall.

In other words, letting a bit of air out of an inflated market isn’t such a bad thing.

Markets plunged more than 1,000 points at Monday’s opening, the sharpest intra-day decline in the history of the Dow Jones Industrial average. Buyers quickly stepped into the void, however, and by 10:30 a.m. ET the Dow was down a still-steep, but far more manageable, 380 points.

David Kelly, chief global strategist at JPMorgan Funds, noted that the selloff in U.S. stocks that began last week is apparently based solely on fears related to China. The U.S. economy, he noted, is on pretty firm ground.

“U.S. economic weakness isn’t behind the selloff – economic numbers since the start of this month have been generally very positive, with a solid employment report, very strong vehicle sales, and better-than-expected readings on retail sales, housing starts and existing home sales,” Kelly said.

And economic data set for release this week – notably a revision to second quarter GDP that is expected to be revised upward from its original reading – “should also be generally cheerful,” Kelly said.

Fed Rate Decision Not Tied to Stock Markets

What’s more, Kelly said by some technical measurements stocks aren’t overvalued when compared to average valuations over the past two decades.

“In absolute terms, valuations look average – in relative terms, they look cheap,” he said.

An imminent decision by the Fed on the timing of the first interest-rate hike since the financial crisis should also not be blamed for the current selloff, according to Kelly. The Fed has been telegraphing the move for months and policy makers have made it clear that rate hikes will be gradual once they start.

Besides, the Fed hasn’t tied itself to a liftoff date, saying repeatedly that the decision will be data-dependent, which leaves room for the central bank to postpone the rate hike beyond September when the decision was widely-expected.

But if the move is delayed it won’t be because central bankers fear a market selloff. It will be delayed because central bankers fear higher borrowing costs brought on by higher interest rates will create an obstacle to the ongoing economic recovery.

New York Fed President William Dudley said as much late last year: “Let me be clear, there is no Fed equity market put. To put it another way, we do not care about the level of equity prices, or bond yields or credit spreads per se. Instead, we focus on how financial market conditions influence the transmission of monetary policy to the real economy."

Dudley added, “At times, a large decline in equity prices will not be problematic for achieving our goals. For example, economic conditions may warrant a tightening of financial market conditions. If this happens mainly via the channel of equity price weakness--that is not a problem, as it does not conflict with our objectives.”