The Fed Issues a Clear Warning…But Will Anyone Listen?

You know those pharmaceutical TV commercials that end with unexpected, eye-opening warnings like “May cause brain melting, jungle rot, and halitosis if taken on a day that ends in a Y?”

Well, let me introduce you to the Federal Reserve’s latest Financial Stability Report…

…in some markets, prices are high compared with expected cash flows. House prices have increased rapidly since May, continuing to outstrip increases in rent [meanwhile] asset prices remain vulnerable to significant declines should investor risk sentiment deteriorate, progress on containing the virus disappoint, or the economic recovery stall.

Allow me to summarize: Things. Are. Not. Looking. Good.

This is the modern version of former Federal Reserve Chair Alan Greenspan’s “irrational exuberance” moment almost exactly a quarter century ago—December 1996—during a speech at the American Enterprise Institute.

In that now-infamous speech, Greenspan warned about overhyped stocks related to this newfangled contraption called the “internet.”

I went back and looked. Greenspan’s speech meant precisely zilch. The S&P 500 in December fell about 2%…then shot off like a rocket, gaining just over 100% before the dot-com bubble finally burst several years later.

I don’t see that happening this time.

Greenspan was too early with his warning.

Today’s Fed is too late.

Back at the end of ’96, the S&P was trading at a P/E ratio of 24.8. It would peak at 43.8 in the early months of 2000, just before the canoe tipped over. (The P/E, or price-to-earnings, ratio basically defines how cheap or dear a market or individual stock is; the higher the P/E, the more expensive the market or stock. Here I’m using the Shiller P/E ratio, which takes a more holistic, decade-long, and inflation-adjusted measurement.)

These days, the S&P trades at a P/E of 39.5.

In the history of Wall Street, that level was only bested by the tech bubble of the late-’90s. And when that bubble burst, stocks plunged more than 40%.

I’m not saying a crash is imminent. But I’m not not saying that, either.

If you’ve been keeping up with Jeff, you likely know I was early to the exits. I left the theater last summer by selling most of my stocks.

True, there’s been a lot of action and fun and a party-town atmosphere inside the theater in the time since. But the patrons aren’t paying attention to the fact that an arsonist has padlocked most of the doors and is gonna set the place ablaze.

Can’t say when. Only that this is obviously the end game.

It has to be. Stock markets, like trees, can’t grow to the sky. At some point…timber!

The Fed is all but telling us that with its latest Financial Stability Report.

I don’t know that anyone will listen.

I mean, no one listened to Greenspan, except to steal his “irrational exuberance” line that has been used ad nauseum over the last 20 years by financial writers (like me) warning “Danger, Will Robinson!” (That will be my only Lost in Space reference this decade, I promise.)

Although I routinely harangue the Fed for being slow on the uptake—and again it’s slow here—giving consideration to their words now is still prudent.

No one knows how high stocks can climb from here. But I can tell you that stock-market leadership—the stocks primarily propelling the gains—is thin and largely reliant on technology.

The Fed Heads are right: Asset prices remain vulnerable to significant declines should investor risk sentiment deteriorate, progress on containing the virus disappoint, or the economic recovery stall.

Each one of those is a very real risk today.

So, just be careful out there. Maybe lighten your stock-market load a bit—particularly in high-flying techy names. Take the profits, be happy, stash ‘em away. The actors are soon to leave the stage in flames.