The Fed Is On Bubble Patrol
Throughout history, financial bubbles have had telltale characteristics: At the outset, new profit opportunities draw investors. As prices rise and buyers are swept up in the euphoria, easy money fuels the process. Soon, mob psychology takes over. But as time passes, people become uneasy about the dizzying heights prices have scaled and start to pull out. Amid a mad scramble for the exits, the bubble bursts.
Today's stock market bears some of these characteristics. Trading has certainly seemed frenzied and irrational, and valuations have gotten historically high. But for the overall market, they haven't touched the 50 or so times earnings Japan's Nikkei stock market exhibited a decade ago. And while U.S. money growth has picked up over the past three years, it hasn't lubricated the market's runup the way Japanese money growth did for many years. Most important, though, the U.S. market's performance hasn't triggered the boom conditions that can unravel entire industries and economies. Real estate prices, while climbing, haven't reached the stratosphere, and inflation hasn't taken off.
Still, this is a market that makes people uneasy, and with reason. Simply put, corporate earnings don't seem to justify current valuations. Defenders point out many props to the market, from the weight of baby boomer demand to the appeal of the U.S. as a safe haven. But stock prices reflect investors' expectations of future earnings, and it has become apparent in recent weeks that investors have probably been too optimistic.
Reported earnings for the 386 of the Standard & Poor's 500-stock index whose results are in for the first quarter are running nearly 5% below estimates. When the Fed let it be known that it might lean toward raising rates in May, it immediately put a damper on the market. In the end, the Fed may not opt to raise rates. Certainly, continued weakness in Japan and much of Asia suggests that the Fed should be cautious about pushing U.S. rates higher at this time. But simply by signaling its inclination, the Fed took some wind out of the market's sails. And that looks like a good thing.