U.S. stocks were on track for a new record on Thursday as Fed Chair Janet Yellen’s testimony made bulls feel even bolder than they have for most of this year. The strong gains are even more timely, given one economist’s warning that developed countries may be in or nearing frothy market territory. He highlighted the symptoms of froth he sees at this time and offered some suggestions for avoiding bubble territory as the world’s central banks look to taper off their monetary accommodation policies.
Yellen reverts to her typical dovishness
During her time as chair of the Federal Reserve, Janet Yellen has been known for her dovish tilt, although after Donald Trump entered the White House, signs of hawkishness began to appear. The Fed started to raise rates, but the bond market didn’t believe that the central bank would continue to raise rates.
Yellen's testimony this week covered much more than interest rates, and she brought back investors' appetite for risk by hinting that borrowing costs might rise more slowly than previously believed. On Thursday, she told the Senate Banking Committee that the federal-funds rate probably doesn't need to increase a lot to reach "a neutral policy stance." She made similar remarks before the House Financial Services Committee when she emphasized that the Fed would raise rates gradually.
Both days of dovish commentary triggered a fresh rise in U.S. equities and served to hand the Dow Jones its first closing record high in almost a month. The S&P 500 also surged on Wednesday and continued to tick higher on Thursday, while the NASDAQ Composite did the same.
Symptoms of a frothy market emerging
But just days before these two days of sudden increases in U.S. equities, Deutsche Bank Chief Economist Mikihiro Matsuoka warned about the growing signs of a frothy market. He said in a special report earlier this week that he believed the stock markets in developed countries are starting to show signs that they're entering frothy territory. Goldman Sachs had similar warnings about the NASDAQ earlier this year.
Matsuoka noted that the "simple average of the standard deviation of the stock market capitalization as percentage of GDP of seven major developed countries" has been approaching the peaks observed in 2000 and 2008.
He warned that symptoms of a frothy market are appearing because monetary accommodation must end eventually, and it's been going on a long time. A frothy market is a precursor to a bubble, and he notes that we won't even know whether we're in a bubble until it bursts. And as developed markets start to end their monetary accommodation, the returns on safe assets should start rising while risk asset valuations begin falling.
Delaying asset price adjustments after monetary accommodation
According to Matsuoka, there are some factors that could be causing each frothy market to avoid or delay a prolonged period of asset price adjustment that tends to be standard after such a long period of extensive monetary accommodation. One factor is if the market keeps its nominal GDP growth above long-term bond yields, but unfortunately, he said the gap between nominal GDP growth and long-term bond yields has growth to a historical high.
He added that a turnaround in monetary policy would reduce this gap naturally. However, just as the Fed and other major central banks around the globe were starting to exhibit signs of a hawkish bias, Yellen displayed her trademark dovishness once again in her two days of testimony this week.
Another factor is equities with dividend yields higher than the long-term bond yields, causing an increase in P/E as investors search for yield. Matsuoka noted that P/E ratios have been rising steadily since the global financial crisis, carried along by monetary accommodation. As a result, Yellen's sudden reversion to dovishness after the Federal Reserve showed signs of a slightly more hawkish tilt was enough to embolden stock bulls again, driving U.S. equity prices higher.
A third is the huge cash piles non-financial firms have stashed overseas. Naturally, big tech firms such as Apple and many others tend to come to mind when considering this last category, and Matsuoka sees such cash hordes as a disappearance of investment or profit opportunities.
