Found via Jon Shayne's Blog.
The pending appointment of Janet Yellen as chair of the Federal Reserve Board of Governors gives me great cause for concern. By all reports, she is highly intelligent and, in the opinion of her peers, highly qualified for her new role.
However, we've seen errors in monetary easing set off a bubble in asset prices and the worst recession since the 1930s, proving that at least one other quality is essential for the job she is about to undertake: the intellectual integrity essential for sound judgement.
Yellen could legitimately defend quantitative easing in a number of ways. She could, for example, argue that the risks of high asset prices are counterweighed by QE's intended benefits, including the prevention of deflation. But, instead, she's defended the program with meritless arguments to claim that equity prices are not at dangerous levels.
The problem is the metric she uses to value equity prices. The metric she uses is a common one: the ratio of stock prices of companies overall to their overall earnings -- the traditional price/earnings (PE) ratio. The PE ratio is based, reasonably, on the premise that when you buy a share of any firm, you're essentially buying a stake in its profits, which will either be given to you directly in the form of dividends or invested on your behalf by the company.
A question, though: what measure of profits to use? Yellen is on record claiming that the PE multiple based on assumptions about next year's earnings can be used to show that the market is not overpriced. Here's what she said in 2011:
"Overall ... indicators do not obviously point to significant excesses or imbalances in the United States. ... forward price-to-earnings ratios in the stock market fall within the ranges prevailing in recent decades, and are well below the early-2000 peak."
This is nonsense. On several occasions in the past, the market, based either on the past 12 months' or the next 12 months' earnings, has appeared to be reasonably priced, despite being demonstrably and dangerously expensive based on more reliable measures.
Those more reliable measures include q, which is the ratio of stock market value to real-world replacement value. (It is similar, but not identical, to James Tobin's q, as I explain here.) Another more reliable measure is the Cyclically-Adjusted Price-Earnings ratio or "CAPE," which compares the value of the stock market not to just one year's worth of earnings, but rather to the inflation-adjusted average of earnings for the past 10 years.
And on the flip side, there have also been times when the market looked expensive based on the 12-month PE, but was demonstrably cheap using the much more reliable q or CAPE.
The point is that in order to know whether a market is expensive or cheap, we need many years of data. Cheap markets often fall in the short-term and expensive markets often rise. We cannot therefore judge whether a stock market was cheap or expensive simply by looking back at the following year's change in the share price. Similarly, we cannot even judge from looking at the return over the subsequent decade, say, because the market 10 years from the starting date may have been heavily depressed (as during the Great Depression) or massively over-priced (as in the Roarin' '20s or the dot.com '90s).
Using prospective earnings today is particularly suspect because no one knows what they will be; such forecasts are habitually overstated and they can be wildly wrong. Why were they used? Even the least cynical must suspect that they were used not because of their virtues but because of their defects.
Had the emphasis been placed on q, Yellen should have been worrying that the market on Wednesday, Nov. 13, (S&P 500 at 1782 ) was 68 percent overpriced according to q and over 80 percent according to CAPE. (It was also over 100 percent overpriced according to the dividend yield and while, admittedly, we know the dividend yield is a poor guide to value, it has at least better claims than the PE based on next year's assumed earnings per share.)
I hope, but do not expect, that Yellen apologizes for the error that she has committed. If she does this, my accusation of a lack of intellectual integrity will be promptly and happily withdrawn. It would provide a welcome change to other comments from central bankers who seem to think they can atone for their past mistakes by obstinately adhering to them.