Yesterday, in a report submitted to congress to accompany Fed Chair Janet Yellen’s testimony, the Federal Reserve did something unusual, but not unprecedented. The board’s statement targeted specific areas of the market in a warning about valuations. The exact comment was “...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." This followed the observation that equity pricing overall seemed reasonable at around historic average multiples of earnings.
The market reacted, with small cap stocks in general and social media and biotech stocks in particular losing ground. Those losses, however, were not as great as one might expect. Twitter (TWTR), for example, closed the day down just over 1 percent, while the SPDR Biotech ETF (XBI) lost 3.86 percent. Both are indicating higher openings this morning.
For volatile stocks and sectors, one day losses such as these are barely a blip on the chart. Even XBI’s nearly 4 percent drop should be looked at in the context of a nearly 85 percent gain from July of last year to February of this. By the end of February, however, the market had already decided that the situation Yellen described was evident and the biotech sector as a whole corrected quickly, losing nearly 30 percent during March and April. This correction would indicate that, while valuations may look a bit stretched, traders and investors are aware of it. There is no “irrational exuberance” in the current climate.
That phrase refers to another time when a Fed Chair pointed out that certain sectors of the stock market were looking somewhat frothy. It was famously uttered by Alan Greenspan in reference to the dotcom bubble of the late 1990s. What many forget, however, is the timing of Greenspan’s comment. It was made on December 5th 1996. The day before, the NASDAQ Composite Index had closed at 1297.02. It reacted to Greenspan’s comments in the very short term, but that small correction only stoked the fire and by January of 2000 the index was above 4500.
Of course, this situation is different, if for no other reason than that we have that experience to look back on, but the basic calculation that fueled that continued price explosion still exists. What the FED board effectively said was that they were shocked that there was gambling going on in the casino. The vast majority of those that invest in speculative areas of the market are fully aware of what they are doing and the risks involved, but the potential rewards are so high that that speculation can be justified.
If a real advance is made in cancer research, for example, and a general cure for cancer is found, then any current multiple of forward earnings for the companies positioned to monetize that is irrelevant. Similarly, if you own the next Google (GOOG), a company that unlocks the key to profit in a booming sector such as social media, any losses in others that fail will pale into insignificance.
I am not suggesting that you, dear reader, or anybody else should rush out and gamble with your hard earned money; it’s just that, given human nature, some will. The metric that the Fed used, multiples of earnings, matter little to those with dollar signs clouding their vision. Just as earlier this year, corrections will come and the volatile sectors of the market will remain volatile, but that doesn’t mean that they have peaked.