Irrational Exhuberance Redux? Greenspan Says Stocks Are Cheap
On the heels of solid first quarter gains, equity markets across the globe have sputtered as of late, as investors wrestle with conflicting signals. Among the many notable data points: Bloomberg recently reported that outflows from U.S. equity mutual funds in April reached their highest level in nearly 30 years. Such capitulation is certain to raise the antennae of contrarians. So are recent comments by former Federal Reserve Chairman Alan Greenspan.
Here is some of the equity-related news that recently caught my eye:
- Greenspan as a Contrary Indicator. At the Bloomberg Washington Summit earlier this month, Greenspan declared that “stocks are very cheap.” It was under Greenspan’s tenure, in 1997, that the Fed famously first published what came to be known as the Fed Model, which compared the forward earnings yield on stocks to the yield on the 10-year Treasury Bond. First dubbed the “Fed model” by economist Ed Yardeni, this theory has been discredited many times over the years, perhaps most famously in 2002 by hedge fund manager Cliff Asness. In “Fight the Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, and Future Return,” Asness argued that the Fed model creates a “money illusion” by comparing “an often exaggerated [earnings yield] to an irrelevant benchmark (nominal yield).” In any event, critics of Greenspan’s tenure at the Fed — there’s no shortage — may want to consider his bullish call on stocks a contrary indicator.
- Flawed Financial Models. At the 65th CFA Institute Annual Conference in Chicago, keynoter James Montier spoke of “the flaws of finance.” Noting that “bad models, bad policies, bad incentives, and bad behavior” were directly responsible for the recent financial crisis, he warned that we are doomed to repeat history without fundamental changes in how we define and manage risk. Montier was especially critical of Wall Street’s ongoing efforts to “impress with complexity” and regulators’ role as enablers.
- JPM Beaches Its Whale. Almost as if on cue from Montier, JPMorgan Chase announced that it had booked a $2 billion trading loss related to a failed hedging strategy involving the use of credit default swaps, reportedly by a trader in the bank’s chief investment office nicknamed the “London whale.” The bank’s stock promptly lost more than $14 billion in market capitalization and, not surprisingly, critics of “too big to fail” banks and supporters of the proposed Volcker Rule, including CFA Institute, highlighted this story as further evidence that these large financial institutions need to be reined in. Two weeks before the JPMorgan trading loss was announced, banking industry expert Christopher Whalen presciently spoke of the risks that big banks still pose to the financial system, noting that “credit default swaps are all about moving the risk to the dumbest guy in the room.” JPMorgan should consider itself exposed.
- “Woodstock for Capitalism.” Berkshire Hathaway recently held its annual meeting. The New York Times blow-by-blow account suggests that Chairman Warren Buffett and second-in-command Charlie Munger were met, as they usually are, by a fawning audience. And, as has been the case in recent years, succession plans seemed to be on the mind of most observers. Bloggers John Hempton and Jeff Matthews, who also wrote Secrets in Plain Sight: Business & Investing Secrets of Warren Buffett, both provided entertaining and informative takes on the meeting.
- Blessing in Disguise? Berkshire Hathaway had committed to provide financing for the recently withdrawn offer by Coty to buy Avon Products. While Buffett no doubt saw Coty and Avon as a winning combination, the odds, it turns out, would have been stacked against them. In a study recently published by the National Bureau of Economic Research, titled “Winning by Losing: Evidence on the Long-Run Effects of Mergers,” the authors find that winning bidders go on to underperform losing bidders by a significant margin.
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