Fed’s Bubble Alarm Stuck on Snooze
The Federal Reserve’s policy of unrestrained quantitative easing has worked like rocket fuel for U.S. stocks this year. Case in point: Rocket Fuel Inc.
It’s the sort of company that probably couldn’t have done an initial public offering absent a raging bull market. Rocket Fuel says its business is “big data” and “artificial intelligence” (as opposed to real intelligence). Mainly, it helps advertising agencies place orders for online ad campaigns.
Rocket Fuel went public in September at $29 a share. It now trades for about $51, giving it a $1.7 billion stock-market value. That’s about 11 times its revenue for the previous four quarters. And forget profits: Rocket Fuel had almost $20 million in net losses during the same stretch. One example doesn’t establish that we’re in a market bubble, obviously. But this is the kind of anecdote you would expect to see in one.
Just for the sake of perspective, today’s stock-market valuations aren’t as frothy as they were during the great dot-com bubble of more than a decade ago. At the end of 1999, the Nasdaq 100 Stock Index had a price-to-earnings ratio of 99, according to data compiled by Bloomberg. At the end of March 2000, shortly after the Nasdaq peaked, that ratio was 137. Today, it’s about 21. The S&P 500 Index’s price-to-earnings ratio, by comparison, is about 17, which is neither cheap nor outrageously expensive by historical standards.
Yet there are pockets of bubblelike behavior in plain sight. A new company, Fantex Inc., last month filed to go public while sporting only one source of future revenue: the earnings potential of Houston Texans running back Arian Foster, who promptly pulled a hamstring muscle. (It has since signed a second athlete.)
The biggest names in the stock market nowadays -- “story stocks” or “momentum stocks,” they’re sometimes called -- include social-media companies such as LinkedIn Corp. ($27 billion stock-market value, 18 times revenue and 746 times earnings) and Facebook Inc. ($122 billion market cap, 18 times revenue and 120 times earnings). Then there’s the electric carmaker Tesla Motors Inc. ($19 billion market cap, 14 times revenue and losing money) and the online-entertainment company Netflix Inc. ($19 billion market cap, 4.5 times revenue and 186 times earnings).
As investment manager Michael Gayed of Pension Partners LLC wrote in an article this week, these companies can be good barometers of market sentiment. “When they are rising and outperforming, it is generally favorable for the market and risk appetite,” he wrote. “When they are falling and underperforming, it is often a cautionary signal for the overall market.” Lately these stocks have been coming down from their highs, although they’re still up much more than the S&P 500 Index for the year.
The Fed’s role in the markets’ surge is no mystery. By maintaining its zero interest rate policy and monthly asset purchases of $85 billion, the central bank has crowded investors out of havens such as Treasury bonds and pushed them into riskier assets such as equities and speculative-grade debt. Even the slightest hint that the Fed might taper its purchases has sent bond and stock prices reeling. When the Fed walks back from those hints, markets have rebounded.
Corporate-debt spreads have narrowed severely. Covenant-light leveraged loans are back in vogue. Housing is soaring again in the same markets where it went bust years ago. In San Francisco, Los Angeles, San Diego and Las Vegas, home prices in August were up more than 20 percent from year-earlier levels. The S&P/Case-Shiller index of prices in 20 big U.S. cities is back to mid-2004 levels. It has been heaven for speculators. The Fed could stop the music at any time with one stroke.
The most attention-grabbing calls for the Fed to pull back are coming from Wall Street itself. This week, Larry Fink, chief executive officer of BlackRock Inc., the world’s largest money manager, said that “it’s imperative that the Fed begins to taper” and that “we’ve seen real bubblelike markets again” in both equities and corporate bonds. Bill Gross of Pacific Investment Management Co., manager of the world’s largest mutual fund, wrote this week on Twitter: “All risk asset prices artificially high.”
Even the CEOs of Tesla and Netflix have expressed amazement at their stocks’ recent surges. In an Oct. 21 letter to shareholders, Netflix’s Reed Hastings compared his company’s stock performance with the “momentum-investor-fueled euphoria” of 2003, the year after Netflix’s IPO. Tesla’s Elon Musk last week said his company had “a higher valuation than we have any right to deserve.”
There is no simple formula the Fed can use to determine if the markets have become too inflated or its own balance sheet too large. These are ultimately judgment calls. Yet one of the problems with the Fed is that for more than a decade, it has erred on the side of letting bubbles grow largely unchecked or acting as if they don’t exist, then reacting to the ensuing damage by blowing new ones. If the Fed can’t spot signs of bubbles forming now, that’s because it doesn’t want to.
(Jonathan Weil is a Bloomberg View columnist.)
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