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Yellen’s jibe at stock sectors echoes Greenspan’s warning in 1996

Janet Yellen, chair of the U.S. Federal Reserve, has an important message for investors: Stocks trading at 100-times earnings have "stretched" valuations.

While that may sound a bit obvious to anyone who prefers to invest in stocks with price-to-earnings ratios in the mid-teens, her comments hit a nerve among some investors who turned value conscious after hearing the warning.

Particularly frothy stocks such as Facebook Inc. and LinkedIn Corp. fell 1.1 per cent and 0.8 per cent, respectively, on the news, and the Nasdaq Biotech index fell 2.3 per cent. The S&P 500 ended the day down 0.2 per cent after hitting a record high in the morning.

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Ms. Yellen delivered her observation during off-script Congressional testimony on Tuesday. Well, sort of: She was actually singling out social media and biotech stocks – along with lower-rated corporate debt – as pockets of the market that look frothy and are vulnerable to setbacks, particularly when the Fed starts raising its key interest rate.

The fact that a Fed chair would discuss stock valuations of any kind is highly unusual and should push investors into evaluating market conditions after a 190 per cent rally by the S&P 500 over the past five-and-a-half years.

It echoes to some extent the "irrational exuberance" warning from former Fed chair Alan Greenspan in 1996, during the run-up to the dot-com bubble – though Ms. Yellen's comments were far more direct.

"Even during the great tech boom of the late 1990s, which of course ran for years, I don't recall Greenspan ever being that specific," said Douglas Porter, chief economist at BMO Nesbitt Burns.

So, is Ms. Yellen hinting that there's a bubble forming here?

A number of market strategists have pointed out that overall valuations are above historical averages and that U.S. stocks run the risk of "melting up" – where prices surge to unsustainable levels, largely because of ongoing Fed policy stimulus.

Others, such as asset manager Jeremy Grantham of GMO, believe Fed policy is irresponsible and will bring about a disastrous collapse in stocks.

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But Ms. Yellen isn't exactly pulling the alarm here. Indeed, she said in her confirmation hearing in November that stocks had risen "robustly" but that there was nothing to suggest "bubble-like conditions."

Despite the S&P 500's move deeper into record-high territory this year, she appears to have the same worry-free view on the broader market today.

"While prices of real estate, equities and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms," she said in her prepared remarks.

The Fed does not set monetary policy based on stock prices. Instead, its mandate is limited to full employment and stable inflation.

On that subject, Ms. Yellen sounds as though she doesn't want to raise interest rates any time soon from their current ultra-low level of about zero per cent. Too many Americans remain unemployed, she said; inflation is below the longer-run objective.

Then what is she getting at with her jibe at a select group of stocks with ridiculously high stock valuations?

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Mr. Porter thinks that by singling out where she sees excesses in the stock market, Ms. Yellen could be trying to take some steam out of the market without having to alter monetary policy in the near term.

"And it seems to have worked, at least for a day," he said. "It's debatable how effective this jawboning tactic will be looking further ahead."

Peter Buchanan, senior economist at CIBC World Markets, even argued that investors in those high-flying technology and social media stocks shouldn't despair over Ms. Yellen's comments, based on the Fed's dismal track record for poor timing. Mr. Greenspan's irrational exuberance warning in 1996, after all, missed the peak of the dot-com bubble by more than three years.

"I trust the Fed's judgment on the economy," Mr. Buchanan said. "I'm not quite as ready to put my money down when the Fed is talking about stock market valuations."

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