The Fed meeting getting underway today remains the dominant issue for the markets, with investors trying to handicap whether the ‘Taper’ decision will finally come through tomorrow afternoon or get deferred to sometime early in 2014. The lack of inflation pressures in the economy often gets cited as providing the Fed with the flexibility to stay on current course. And this morning’s benign CPI reading further strengthens that line of argument.
But while there is no consumer price inflation, the evidence is all around us of asset price inflation. Stocks and bonds are the most liquid of these assets that have been in a bull run lately, but even the prices of illiquid assets like artwork and agricultural land are in record territories. The stock market may not be in a bubble, as some bears want us to believe. But it isn’t cheap either, as the Fed’s extraordinarily loose monetary policy has artificially suppressed discount rates, throwing valuations out of sync with ground realities.
Traditional valuation metrics like price-to-earnings ratios for the broad market indexes, like the S&P 500, certainly don’t look that stretched relative to historical high-points for the market. But we should be careful when we look at such valuation metrics across different time periods as the comparisons may not be appropriate without factoring in the underlying interest rate backdrop at the time. Valuations are a function of interest rates and interest rates have been artificially held down by the Fed, particularly through its bond-purchase program.
The Fed plans to embark on a new experiment where it will try to substitute the $85 billion a month in bond purchases with verbal assurances (the so-called forward guidance). But as we have seen in the almost doubling of long-term treasury yields since May when the Fed first floated the Taper idea, the bond market may not be as appreciative of verbal promises as it was of actual bond purchases.
[Listen to: Bud Conrad: The Fed Was Spooked by a Rise in Interest Rates]
This is the reason for stock investors’ nervousness over the prospect of QE Taper, whether it arrives on Wednesday or sometime early next year. And they should be. After all, QE may not have caused any consumer price inflation, as today’s CPI report reconfirms. But it has inflated the prices of stocks and a host of other assets.
