The US Central Bank Is Warning Of Danger In Stocks

Here’s an excerpt of a speech by the leader of the Federal Reserve, the central bank of the US, warning of danger in stocks in the country:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past.

But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?

We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy.

But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.”

Trouble ahead?

Are you worried about the implications of the speech? Don’t be. That’s because the speech was delivered on 6 December 1996 – more than 23 years ago – by Alan Greenspan, who was the chairperson of the Federal Reserve at the time. Greenspan’s speech has since become well-known for the phrase “irrational exuberance” because it happened only a few short years before the infamous Dotcom bubble in the US imploded in late 2000. 

But what’s really interesting is that the S&P 500, the major benchmark for the US stock market, has gained 526% in total including dividends, from December 1996 to today. That’s a solid annual return of 8%. This reminds me of two important things about investing.

Worries, worries

The first thing is, to borrow the words of the legendary fund manager Peter Lynch, “there is always something to worry about.”

The content of Greenspan’s speech could well be used to describe the financial markets we’re seeing today. The S&P 500 has bounced 36% higher (as of 28 May 2020) from its 23 March 2020 low after suffering a historically steep coronavirus-driven decline of more than 30% from its 19 February 2020 high. Moreover, the S&P 500 has a price-to-earnings (P/E) ratio of 22 today, which is not far from the P/E ratio of 19 seen at the start of December 1996.

Yet anyone who got scared out of the US stock market back then by Greenspan’s speech, and crucially, failed to reinvest, would have missed out on more than 23 years of good returns. Some individual stocks in the US have delivered significantly higher returns, so the opportunity costs for anyone who stayed out would have been immense.

Time heals

The second thing is, time can wash away plenty of mistakes in the financial markets.

The past 23-plus years from 1996 to today contained plenty of jarring episodes for the economies and the financial markets of the US and many other countries. Here’s a short and incomplete list: The 1997 Asian Financial Crisis; the bursting of the Dotcom bubble in late 2000 that I already mentioned; the 2008-09 Great Financial Crisis; Greece’s debt crisis in 2015; Italy’s banking troubles in 2015; and the US-China trade war in 2018. 

Yet, investors who stayed invested have been rewarded, as Corporate America grew steadily over the years.

Words of caution

I’m not saying that the US stock market will be higher 1 or 2 years from now. Nobody knows. When the Dotcom bubble burst after Greenspan gave his famous “irrational exuberance” speech, the S&P 500 fell by nearly half. It recovered, only to then get crushed again during the 2008-09 Great Financial Crisis. The chart below shows this.

What I want to illustrate is that it makes sense to invest even when the world is mired in trouble, if we have a long time horizon for our investments. 

Now, I want to stress that having a long time horizon is not a magical panacea. 

If our portfolio is filled with stocks that have lousy underlying businesses, staying invested for the long run will destroy our return. This is because such a portfolio becomes riskier the longer we hold onto it, since value is being actively eroded.

If we invest in stocks at ridiculous valuations, staying invested can’t save us too. Japan’s a great example. Its main stock market barometer, the Nikkei 225 index, is today more than 40% lower than the peak seen in late 1989. This is because Japanese stocks were valued at nearly 100 times their inflation-adjusted 10-year average earnings near the late-1989 high. The good thing is Japan-level bubbles are rare. It’s the exception, not the norm. 

So, if the stocks we own today have reasonable valuations and have decent-to-great underlying businesses, we can afford to be patient. In such cases, time can be a great healer of stock market wounds.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.