On July 15, Fed Chair Janet Yellen testified before the US Senate Committee on Banking, Housing, and Urban Affairs. She presented the Fed’s semiannual Monetary Policy Report (MPR) to the Congress. In her prepared remarks, she stated that while valuation seems “stretched” in some areas of the bond market, equities “remain generally in line with historical norms.” Yet in the MPR, which bears her signature, the following observation appeared: “Nevertheless, valuation metrics in some sectors do appear substantially stretched--particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.”
In other words, in her opinion, the stock market is showing some signs of irrational exuberance. Of course, this term was popularized by Fed Chair Alan Greenspan in a speech on December 5, 1996 indicating his concern about a possible bubble in stock prices. About two years later, on January 28, 1999, in testimony before a Senate Committee, he defended the mania in Internet stocks by offering his Lottery Principle. The following is a reconstruction of various quotes picked up by the press from his response to a question about this issue:
“In addition, one has to wonder whether it is even appropriate for the Fed to express opinions about specific stock groups. Lots of sophisticated investors purchase biotech companies that have no earnings and are regularly raising cash to stay in business. These investors do so knowing that the outcomes are binary: The companies they invest in will either find a cure for a disease or they won’t. Their new drugs will either be approved by the FDA or they won’t. They might be acquired for a huge premium or they might not, or might go out of business. Why should the Fed weigh in on the valuation of biotechs? After all, speculators are providing the funding that might actually cure diseases. Or they might get wiped out. Why should the Fed get in the middle?”
Within days of Yellen’s testimony, Facebook Inc (NASDAQ:FB), Google Inc (NASDAQ:GOOGL), and Twitter Inc (NYSE:TWTR) all reported better-than-expected results for Q2 earnings. The S&P 500 Internet Software & Services stock price index is up 17.0% from this year’s low on May 8. Forward earnings rose to a new record high in mid-August. The stocks seem expensive with the forward P/E around 20. But that’s also the expected annual growth rate for earnings over the next five years.