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Buy, Sell, or Crash? Fed Warns on Stocks and Look what Happens

by Wolf Richter, Wolf Street:

If history is the guide, you’re on your own.

The Fed has planted three separate warnings on high stock prices into its March-meeting Minutes, released last week. In the past, the Fed has warned on various occasions on high stock prices, with, let’s say mixed results. Stocks have crashed after warnings, and they have crashed without warnings, and they have soared after warnings.

Perhaps the most infamous warning on stock prices was when Fed Chairman Alan Greenspan on December 5, 1996, said in a speech that “irrational exuberance has unduly escalated asset values.” Stocks quaked in their boots for about one breath then soared for another three years and three months before totally crashing.

So now we’re getting a slew of Fed warnings. The most recent – three of them at once – were spread across the Minutes of the March meeting:

Broad equity price indexes rose further, leaving some standard measures of valuations above historical norms.

[…]
Broad U.S. equity price indexes increased over the intermeeting period, and some measures of valuations, such as price-to-earnings ratios, rose further above historical norms. A standard measure of the equity risk premium edged lower, declining into the lower quartile of its historical distribution of the previous three decades.

[…]
Many participants discussed the implications of the rise in equity prices over the past few months, with several of them citing it as contributing to an easing of financial conditions. A few participants attributed the recent equity price appreciation to expectations for corporate tax cuts or to increased risk tolerance among investors rather than to expectations of stronger economic growth. Some participants viewed equity prices as quite high relative to standard valuation measures.

And here is what Greenspan said on that fateful December 5, 1996. Note the implications as he saw them for monetary policy:

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.

Upon Greenspan’s warning, stocks barely wobbled long enough to notice before they skyrocketed into what would become the Dotcom Bubble … and the Dotcom Crash three years and three months later. While Greenspan might not have worried about falling stock prices per se in his speech, he still got cold feet deep into the crash and radically lowered interest rates, thus kicking off the credit bubble that also contained a housing bubble, all of which collapsed.

Read More @ WolfStreet.com

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