Folly of the Fed

I feel (a little) bad for picking on Bob yesterday.  I’m sure I’ll get past it and I doubt the folks at Nuveen are losing sleep over it.  In any event, I thought we’d take the spotlight off Bob today and shine it where it counts.

Janet Yellen is highly intelligent and, in the opinion of her peers, highly qualified for her new role.  However at least one other quality is essential for the job she is about to undertake: the intellectual integrity essential for sound judgement. Andrew Smithers explains Why Yellen May Be A Dangerous Choice:

Yellen could legitimately defend quantitative easing in a number of ways. She could, for example, argue that the risks of high asset prices are counterweighed by QE’s intended benefits, including the prevention of deflation. But, instead, she’s defended the program with meritless arguments to claim that equity prices are not at dangerous levels.

The problem is the metric she uses to value equity prices. The metric she uses is a common one: the ratio of stock prices of companies overall to their overall earnings — the traditional price/earnings (PE) ratio.

A question, though: what measure of profits to use? Yellen is on record claiming that the PE multiple based on assumptions about next year’s earnings can be used to show that the market is not overpriced. Here’s what she said in 2011:

“Overall … indicators do not obviously point to significant excesses or imbalances in the United States. … forward price-to-earnings ratios in the stock market fall within the ranges prevailing in recent decades, and are well below the early-2000 peak.”

This is nonsense. On several occasions in the past, the market, based either on the past 12 months’ or the next 12 months’ earnings, has appeared to be reasonably priced, despite being demonstrably and dangerously expensive based on more reliable measures.

Those more reliable measures include q, which is the ratio of stock market value to real-world replacement value. Another more reliable measure is the Cyclically-Adjusted Price-Earnings ratio which compares the value of the stock market not to just one year’s worth of earnings, but rather to the inflation-adjusted average of earnings for the past 10 years.

The fact that Janet Yellen chose the criterion most likely among this group to give a misleading signal raises the issue of intellectual integrity. Possible explanations are ignorance and the wish to defend the quantitative easing policy that has taken place on her watch. Ignorance about these other metrics is unlikely. Janet Yellen is married to Nobel Laureate George Akerlof who has co-authored economic papers with the newest Nobel Laureate, Bob Shiller, who has been the most prominent proponent of the use of CAPE to evaluate whether the current level of the stock market is out of line historically. Ignorance, even if true, does not strike me as a valid excuse.

Those who use their position as (then) deputy chair of the Fed surely have a duty to study the literature on a subject before pronouncing conclusions which have major policy implications.

Where we have the actual data, ratios based on prospective data have a worse correlation with hindsight value than PEs based on the earnings-per-share for the past 12 months and considerably worse than the dividend yield.

Using prospective earnings today is particularly suspect because no one knows what they will be; such forecasts are habitually overstated and they can be wildly wrong. Why were they used? Even the least cynical must suspect that they were used not because of their virtues but because of their defects.

Had the emphasis been placed on q, Yellen should have been worrying that the market, on Wednesday, Nov. 13, (S&P 500 at 1782 ) was 68 percent overpriced according to q and over 80 percent according to CAPE.

No hard feelings Bob.  Shame on you Janet.