NEW YORK—It has been three years since Federal Reserve Chairman Alan Greenspan first voiced the notion that high U.S. equity valuations may reflect an "irrational exuberance" on the part of investors. Since then, stocks in general and high-tech stocks in particular have appreciated significantly. Today, the S&P 500 is trading at a record price to earnings ratio of 30, while the equity risk premium, as measured by the spread between equity and 10-year bond yields, is at an all-time low. Greenspan, for his part, has continued to publicly muse over stock valuations.
The big question in his mind, as in all of ours, is this: Are investors truly underestimating the risk of stocks, or does the emergence of an information technology economy justify lower equity-risk premiums and permanently higher valuations?
In the last few years, the U.S. economy has turned in an extraordinary performance, characterized by rising productivity and earnings, declining inflation and interest rates as well as falling business-cycle and earnings risk. These trends all justify higher stock valuations. But another major contributor to higher stock valuations has been the Fed itself, through its asymmetric policy approach to equity market extremes.
Having learned from the bitter deflationary experience of the 1930s and more recently from Japan's woes, the Fed has avoided the mistake of pursuing tight monetary policy in an attempt to rein in bullish stock prices and valuations. In the face of collapsing stock prices, however, the Fed has eased aggressively with the goal of forestalling potential problems for the financial system and the economy as a whole. Greenspan first instituted this aggressive easing response during the stock market crash of October 1987. His move to provide unlimited liquidity to the markets is widely credited with having prevented a financial and economic meltdown. But success often has a way of sowing the seeds of its own undoing. What was a brilliant policy response in 1987 has become questionable in the 1990s.
We witnessed Fed easing when the Asian crisis in 1997 and the Russian crisis in 1998 provoked collapses in equity markets. In the grand scheme of things, this policy response may have been warranted, especially with regard to Asia, whose difficulties had a direct and unambiguous deflationary impact on the U.S. economy. Cumulatively, however, these policy responses have had an unintended consequence. By putting a floor under stock prices, the equivalent of providing an "insurance policy" to equity investors, the Fed has actually helped lower the equity risk premium and fueled a possible speculative bubble in stock prices.
The Fed's asymmetric policy approach has had another effect on stock valuations. While many new growth companies with unproven track records are valued astronomically, a large number of established companies with solid fundamentals trade at huge discounts to the market. Such relative valuation extremes are in part explained by the absence of moral hazard engendered by the Fed's "equity insurance," which has encouraged investors to focus solely on return and to engage in riskier undertakings. This is similar to the situation that prevailed in the savings and loan industry in the 1980s, when federally financed deposit insurance led these institutions to take ever riskier bets.
The problem today is that the Fed has become a prisoner of its own policy. In recent years, stock valuations have increasingly reflected an anticipated easing of monetary policy in response to a sharp decline in equity prices. At the same time, the well-being of the economy has become more and more dependent on the stock market. The accepted wisdom is that the Fed cannot afford to hurt investors for fear of a severely negative impact on the economy. Looking back, the time to have dismantled the safety net under the savings and loans industry was the mid-1980s, when the economy was strong. It didn't occur then but optimally should have.
Similarly, now is the time to reintroduce moral hazard into the equity market, given the strong underlying economic fundamentals that prevail in the United States today. The Fed should let stock prices correct freely and not ease in response to a sharp fall in stock prices, even if that means having to accept some negative impact on the economy in the short run. This would re-establish a more realistic assessment of risk by investors and assure greater financial and economic stability in the long run.
