In 1996, Alan Greenspan didn’t mean to say the markets were suffering from irrational exuberance, he just implied it when discussing whether or not central bankers should worry about the stability of asset prices:
Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?
After mentioning how concerned the Federal Reserve must be with asset price stability, Greenspan presided over one of the largest asset bubbles in modern history over the next three years. Almost 18 years later when the S&P 500 is again making new highs, Janet Yellen has waded into the market commentary space with the Federal Reserve’s recent Monetary Policy Report. The valuation of a smaller class of equities is questioned:
Some broad equity price indexes have increased to all-time highs in nominal terms since the end of 2013. However, valuation measures for the overall market in early July were generally at levels not far above their historical averages, suggesting that, in aggregate, investors are not excessively optimistic regarding equities. Nevertheless, valuation metrics in some sectors do appear substantially stretched—particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year. Moreover, implied volatility for the overall S&P 500 index, as calculated from option prices, has declined in recent months to low levels last recorded in the mid-1990s and mid-2000s, reflecting improved market sentiment and, perhaps, the influence of “reach for yield” behavior by some investors.
On a price to book basis, it does look like valuations are stretched in biotech companies.
The value of biotech companies, and social media companies
for that matter, come from intangibles that aren’t measured in book value and
are yet to be captured in earnings. What
the high valuation tells us is that investors think the expected value of these
companies is higher relative to its tangible book value than it has been in the
past. That may be because the drugs the new companies are working are particularly
promising, or because investors have decided to value the lottery-like payout
of biotech stocks at higher prices. But either way, investors can’t be said to
be “reaching for yield” in these sectors because it’s exactly the wrong place
to look for yield – yield only comes after sales and earnings exist.
The beta of the Nasdaq Biotech index to the market is 1.2, which implies that biotech stock valuations are being moved by factors other than whether or not their drug trials are going well. Part of the explanation may be that in a high liquidity environment the market will value lottery tickets more highly. A higher proportion of companies with no earnings have been going IPO since the 1999 tech bubble. And the companies with no earnings will on average have bigger IPO day pops than companies with earnings. It’s almost as if there is something about real earnings that makes investors look more skeptically at a company.
The Federal Reserve report also mentions low interest rates, and compares them to the mid 90’s and mid 2000’s. Data for implied volatility doesn’t go back much farther than the 90’s, but we can look at the historic volatility as a proxy.
The other time periods that volatility was low were good economic times, the early 50’s and mid 60’s. So while regulators might be worried about the formation of eventual imbalances, it’s much more likely for low volatility time periods to lead to future periods of low volatility and high growth. The next Minsky moment in the US economy is a long way off.