Bernanke Warns But Market Says "Bull!"
Federal Reserve Chairman Bernanke last week testified to Congress that the Fed was studying ways to remove monetary accommodation and trim its monthly asset purchases. After a brief swoon on light volume, share prices rebounded and finished the week only slightly lower. But that wasn't the whole story. The rest of the story was a drop in bond prices and a corresponding increase in interest rates.
After reaching 1.626 percent on May 2nd, the yield on the 10-year Treasury bond increased to over 2.20 percent in early trading on May 29th. That might not seem like a lot, but it is significant in the bond world. The ten-year Treasury is the base rate upon which many loans—and especially mortgage loans—are established. A recovery in the housing market has been crucial to the U.S. economic recovery, and artificially low interest rates have fueled this recovery. A significant rise in mortgage rates would thwart further benefits and may indeed create a problematic headwind. Therefore, the Federal Reserve has been obsessed with keeping these rates low.
A little light reading on the Mortgage Bankers Association website shows that the rate on a 30-year mortgage has increased to 3.9 percent—the highest level since May, 2012. Not coincidentally, mortgage applications have now decreased for a third consecutive week. In this latest week, mortgage applications were down 8.8 percent from one week earlier, while applications for refinancings were down over 12 percent. The Refinance Index is now at its lowest level since December 2012.
We suspect that a perfectly well-intended plan may have backfired on dear Mr. Bernanke. If it was his intention to cool the exuberance on Wall Street as an early tactic to prepare investors for a winding down of its monthly purchases, he may have failed. He failed in an unexpectedly magnificent way in that stock prices remained little-fazed, but bond yields have risen substantially. The wrong market listened! The Fed now confronts higher interest rates, which may require additional bond purchases to reverse the increase. In addition, a commitment to additional asset purchases could drive equity prices into a further frenzy.
It has been historically rare for a Federal Reserve Chairman to focus much on equity prices—yet Bernanke has. In February's Congressional testimony, he said, "I don't see evidence of an equity bubble." Mr. Bernanke said stock prices don't appear to be overvalued, corporate earnings are high and equity risk premiums — the added return investors demand for holding stocks—are above normal. The dual mandates for the Federal Reserve are high employment and low inflation. Managing the appropriate level for stock prices should not be the concern of any government official or central banker.
Bernanke's approach to restoring the U.S. economy has been many faceted. The two core tactics have been to re-inflate housing prices and re-inflate stock prices. By creating wealth among Americans, the Fed hopes they will spend and hire and that the economy will grow. It strikes us as both risky and inappropriate for the Federal Reserve to establish acceptable value levels in any free-market enterprise like the U.S. equity market.
(Read More: Slow Growth Emboldens Fed to Stay the Course)
Mae West quipped that "too much of a good thing can be wonderful." While we enjoy "wonderful" as much as anyone, we are reminded of the first commandment of investing: buy low and sell high. No matter what the Federal Reserve says, the appropriate level for stock prices cannot be determined by simply taking a quick snapshot of the market's price-to-earnings ratio. If it were that easy, anyone could do it! As we mentioned last week, the Fed must (at the very least) consider that profit margins are near record highs. Adjusting the 'e' in 'p/e' to a more normalized level would increase the market's p/e multiple substantially. However, we acknowledge that markets that become overbought can become a lot more expensive and euphoria can last a long time. The question is: Will the enthusiasm for stocks last long enough for the fundamentals to improve In other words, can the Fed successfully prime the pump such that economic growth (and thereby earnings growth) improves and gives investors something tangible to get excited about?
Disciplined investors can always make money over the long-term if they invest in the right things. Color us cautiously optimistic, and be careful out there!
Michael Farr is a contributor for CNBC television and has appeared on numerous broadcasts and has been quoted in global publications. He is a member of the Economic Club of Washington, the National Association for Business Economics, The World Presidents' Organization, and The Washington Association of Money Managers. He is the author of "A Million Is Not Enough," and "The Arrogance Cycle." His new book, Restoring Our American Dream: The Best Investment, debuted in book stores on March 30.