Traders ignore Yellen warning, not a 'good investor'

Rising interest rates spooked stocks far more than a warning from the Fed chair that the equities market is overvalued.

Fed Chair Janet Yellen made the comment in a panel discussion with IMF Managing Director Christine Lagarde. "I guess I would highlight that equity valuations at this point generally are quite high," Yellen said. "They're not so high when you compare the returns on equities to the returns on safe assets like bonds, which are also very low but there are potential dangers there."

Stocks were slammed in afternoon trading with the Dow down triple digits, as the 10-year Treasury edged as high as 2.25 percent. When Yellen spoke in the morning, stocks were already moving lower on the session. The market took a dip down on her comments, but temporarily recovered some losses before the selling reaccelerated.

This is not the first comment by a Fed chair that stock prices are too lofty. Former Fed Chairman Alan Greenspan used the phrase "irrational exuberance" to describe the stock market in 1996. Just last summer, the Fed made an unusually targeted comment about froth in specific parts of the stock market in its Monetary Policy Report. But in both cases, stocks rallied on.

Federal Reserve Bank Chair Janet Yellen holds a news conference following a meeting of the Federal Open Market Committee at the bank's headquarters March 18, 2015, in Washington.
Getty Images
Federal Reserve Bank Chair Janet Yellen holds a news conference following a meeting of the Federal Open Market Committee at the bank's headquarters March 18, 2015, in Washington.

"Her comments are not even an afterthought in terms of (Treasury) price action," said David Ader, chief Treasury strategist at CRT Capital.

Read MoreYellen: Equity valuations are running high

"She's not been right about stocks, so for her to opine about stocks being overvalued is interesting, if you're her stockbroker, but not interesting if you're trading stocks because she's been a bad investor," Ader said.

Michael O'Rourke, chief market strategist at JonesTrading, said Yellen was another negative on an already bad day for stocks. "I think the macros are what's been dominating the action since last week. The Yellen comment didn't help it especially since equities have been on the weak side. You're seeing a lot of trades unwind."

Since the Fed commented on small-cap, biotech and social media stocks being especially frothy last summer, the biotech sector and some social media names have soared. The IBB, iShares Nasdaq Biotech ETF is up 35 percent since July 15, 2014, and Facebook is 16 percent higher, while LinkedIn is up 24 percent. The S&P 500, in contrast, is up just 5.5 percent, as is the small-cap Russell 2000.

Stocks were already moving lower on the day but they took a dip down on her comments before regaining some ground. The Dow was off triple digits midafternoon Wednesday.

Read MoreFed slaps stocks with targeted comments on froth

"Any time you get a market that's already a little bit on edge about when the Fed's going to hike rates, and then you get a Fed chair talking about equities being at high levels, that's just going to make things worse," said Paul Hickey, co-founder of Bespoke. "It's more of a short-term situation, and the market focuses on it then we go back to more important issues. I think the market's less worried about her views on the stock market than her views on interest rates and when they are going to raise them."

Hickey said the market P/E speaks for itself. The S&P 500 price-earnings ratio, at about 17.5 times, is above the average. "I think she definitely has a point. It's hard to say equities are attractively valued at face value here. Valuations are higher than the historical average," he said.

Yellen also took aim at the bond market, which a number of high-profile investors from Warren Buffett to David Tepper said was overvalued just this week.

The Fed chair made it clear that while she does not see a bubble in financial markets, bond yields were down due to low premiums. But bond yields can move rapidly and she noted that was the case in the "taper tantrum" of 2013.

"We need to be attentive and are to the possibility that when the Fed decides it is time to begin raising rates, these term premiums could move up and we could see a sharp jump in long-term rates," she said.

Ader said the Treasury market, selling off with the German bund, may normally have taken those comments as dovish. Treasurys were also under pressure as a large amount of corporate issuance came to market Wednesday.

"When the Fed hikes, that's supposed to take the heat out of the economy. Long rates you would think would actually perform well, and it would be the short rates that would be the issue. That's a weird thing for her to say. If the market had been bid today, for whatever reason, and she came out with that statement, the market would say 'we're up because Yellen just expressed concern about what would happen when she raises rates.'"