Many investors have been warning for months against the U.S. stock market bubble. And just yesterday, Janet Yellen unexpectedly joined this chorus, saying that stock market prices are ‘quite high’. Are U.S. stocks in a bubble territory?

Federal Reserve Chair Janet Yellen said yesterday in a conversation with International Monetary Fund Managing Director Christine Lagarde at the conference "Finance and Society" held in Washington, D.C. that “equity market valuations at this point generally are quite high”. Undoubtedly it is better late than never, however, it is a bit funny that after a few years of unconventional monetary policy with pumping billions of dollars into credit markets and interest rates near zero all the Fed’s official have to say is that “there are potential dangers there”. Yellen also said: “we've also seen the compression of spreads on high-yield debt, which certainly looks like a reach for yield type of behavior”. You don’t say!

Of course, the Fed Chair immediately added that the overall risks to financial stability are "moderated, not elevated" and she does not see the hallmarks of any bubbles. Interesting! There are no signs of the U.S. stocks bubble, no absurdly high Robert Schiller’s cyclically adjusted price to earnings ratio, no market capitalization-to-GDP ratio, which Warren Buffett considered as “probably the best single measure of where valuations stand at any given moment” indicating stock market overvaluation (see the chart below).

Figure 1: Total market capitalization to GDP ratio between 1950 and 2015.

Source: vectorgrader.com

Practically all stock market valuation indicators (look for example at the Tobin’s Q ratio or dividend yield) are painting the same picture: the stock market is overvalued. Investors seem to be aware of this since the proportion of investors saying equity markets are overvalued reached in April its highest level since 2000, according to the Bank of America Merrill Lynch's latest survey of fund managers.

The problem is that as long as the music is playing, investors got to get up and dance. This is because no one wants to be the first person out of the market as long as they're making money; therefore investors are now looking for a warning signal. And this is probably what Yellen wanted to provide, since investors do not expect an interest rate hike earlier than in December. This poses a risk that “when the Fed decides it’s time to begin raising rates, these term premiums could move up and we could see a sharp jump in long-term rates. So we’re trying to... communicate as clearly about our monetary policy so we don’t take markets by surprise”.

On the one hand, Yellen’s message to brace for the end of the stock boom can signal that the Fed is determined to hike interest rates someday, which is rather bearish for gold. On the other hand, if investors exit the stock market, some of this capital would flow into the gold market, which would certainly be positive for the gold prices.

The bottom line is that the U.S. stock market is in bubble territory, which was finally noticed by the Fed. It does not mean that we will see the stock market bubble burst soon, however, investors should be aware that such a risk exists. The possible end of the stock market boom (and the resulting rise in market uncertainty) should be positive for the gold prices, however, the aim of Yellen’s statement could be to prepare investors for the interest rates hike.

Thank you.

Arkadiusz Sieron
Sunshine Profits‘ Gold News Monitor and Market Overview Editor

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