The Marriner S. Eccles Federal Reserve building stands in Washington, D.C., U.S., on Tuesday, Aug. 18, 2020.
Erin Scott | Bloomberg via Getty Images
The Federal Reserve has come a long way from the days of warning about “irrational exuberance.”
Former Fed Chairman Alan Greenspan famously sent up a flare in December 1996 about stretched asset valuations triggered by wild dotcom speculation that had produced an unbridled bull market.
It took three years for the warning from “The Maestro” to come true, but the statement is still considered a seminal moment in market history where a Fed leader issued such a bold warning that went unheeded.
Flash forward 25 years and the attitude from the Fed is considerably different, even though market valuations look a lot like they did back around the time the dotcom bubble first.
Central bank officials repeatedly have been given the opportunity to advise caution on asset valuations, and each time they have largely passed. Other than acknowledging that prices are higher than normal in some instances, Fed speakers have largely attributed market moves as the product of an improving economy buoyed by aggressive fiscal stimulus and low interest rates that will be in place for years.
Just a few days ago, San Francisco Fed President Mary Daly spoke on the issue and said the Fed has no intention of tightening policy even in the face of roaring bull markets across several asset classes.
“We won’t be preemptively taking the punchbowl away,” Daly said during a virtual Q&A Wednesday.
The “punchbowl” metaphor was interesting in that the term became a bit of a pejorative following the 2008 financial crisis.
Its origin in policy circles dates back to William McChesney Martin, the longest-serving Fed chairman who held the position from 1951-70. The Fed’s role, Martin said, was to act as a “chaperone who has ordered the punchbowl removed just when the party was really warming up.” The statement delineated the cautionary role the Fed should be playing when it spots signs of excess.
But Daly implied that such a duty either does not exist today or is not relevant to the current situation.
“That’s something that worked maybe in the past, definitely doesn’t work now, and we’re committed to leaving that punchbowl or monetary policy accommodation in place until the job is fully and truly done,” she said.
Fed critics say the central bank failed to act on its “chaperone” role over the punchbowl in the years leading up to the financial crisis, allowing Wall Street’s exotic investing vehicles devised that capitalized on the subprime lending frenzy to tank the global economy.
The embodiment of those excesses came in another famous quote, from former Citigroup CEO Chuck Prince, who in 2007, a year before the worst of the crisis would explode, said, “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
Citi would later become one of the key players in the crisis after it had to take severe writedowns on the toxic assets that littered its balance sheet.
In the current scenario, the financial system is largely sound. Rather than being a liability, banks have been an asset during the Covid-19 economic crisis.
It’s elsewhere that signs of excess might be found.
The stock market is the easiest place to look.
The S&P 500 has skyrocketed about 75% since its pandemic low on March 23, 2020, pushed higher by low interest rates, an improving economy and hopes that the worst of the crisis is over. The index is trading at about 22 times forward earnings, or a little higher than it did when the dotcom bubble popped.
But there are other areas as well.
Jack Dorsey, CEO, Twitter testifies at Congressional hearing, March 25, 2021.
Bitcoin’s price is 10 times higher than it was a year ago. Blank-check companies have flourished on Wall Street as investors pour cash into special purpose acquisition vehicles without specifically knowing where it’s going. Nonfungible tokens are the latest craze, evidenced in part by Twitter founder Jack Dorsey selling his first tweet this week for $2.9 million.
At a news conference last week, Fed Chairman Jerome Powell gave at least a nod to what’s happening when he noted that “some asset valuations are elevated compared to history.” Otherwise, though, the party is on and the Fed is still pouring the champagne.
That has some investing pros worried.
“This is the problem with the Fed. They’re really good at throwing a party, but there’s always the day after,” said Peter Boockvar, chief investment officer at Bleakley Advisor Group. “There’s always a time when the party ends and everyone is hung over. During that party, people get into accidents and people do stupid things.”
For its part, the Fed said it’s going to keep short-term interest rates anchored near zero and its asset purchases pegged at a minimum $120 billion a month until it reaches a set of aggressive if somewhat squishy goals.
Central bank officials want the economy not only to be running at what appears to be full employment but also for the benefits of that to be spread among income, racial and gender lines. Achieving that goal, they believe, will require allowing the economy to run hotter than normal for a while, with a tolerance for inflation a little above 2% for a period of time.
Boockvar said those policies are misguided and the Fed will regret running policy with such a loose hand.
“Even other central banks understand that in hockey, you go where the puck is headed,” he said. “When you keep rates at zero for a long period of time and tell people they’re staying there, it no longer is stimulative because it creates no sense of urgency to act now.”
Elsewhere on Wall Street, though, the attitude is primarily to go with the flow.
Mary Daly, President of the Federal Reserve Bank of San Francisco, poses after giving a speech on the U.S. economic outlook, in Idaho Falls, Idaho, U.S., November 12 2018.
Ann Saphir | Reuters
Bank of America is advising clients to be a little leerier of stocks than usual and instead invest in real assets – property and commodities in the more traditional sense, but also collectibles, farm and timber assets and even wine. The firm sees real assets as “cheap” and also closely correlated to rising inflation and interest rates.
“Real assets are a hedge for War against Inequality, inflation & infrastructure spending,” Michael Hartnett, the bank’s chief investment strategist, said in a recent note. He said the investing class also benefits from “themes of ‘bigger government & ‘smaller world.'”
From the Fed’s perspective, Daly said she sees “pockets of concern” on valuations, but overall doesn’t see financial conditions as “frothy.”
“We absolutely look at financial stability indicators,” she said. “But we assess it on a broad scale, not just one specific market. We are not in a position to manage the movement of the stock market, which [is] affected by a tremendous number of things.”