But how do we know when irrational exuberance has unduly escalated asset values?
– Alan Greenspan 1996
PIMCO’s dear friend and former counselor Alan Greenspan coined this now famous phrase in the midst of what turned out to be a fairly rationally priced stock market in late 1996. While the market was indeed moving in the direction of “dot-com” fever three to four years later, the Dow Jones Industrial Average at the time was a relatively anorexic 6,000, and the trailing P/E ratio was only 12x. For a central bank that was then more concerned about economic growth and inflation as opposed to stock prices, risk spreads and artificially suppressed interest rates, the Chairman’s query made global headlines, became a book title for Professor Robert Shiller and a strategic beacon for portfolio managers thereafter. Having experienced two and perhaps three bouts of significant market irrationality since Greenspan’s speech (the 1998 Asian Crisis, 2000 Dot-Coms, and of course 2007’s subprime euphoria), investors these days have their ears pressed to the ground and eyes glued to the tape for any sign of renewed irrationality. If the game is now musical chairs as opposed to Chuck Prince’s marathon dancing, it pays to be close to a chair, even as the “can’t miss” euphoria mesmerizes 2013 asset managers worldwide.
Into this academic but high-staked market fog has stepped another Fed official, this time not a Chairman but a relatively new yet similarly quizzical Governor. Jeremy Stein’s February 2013 speech has not gained the attention that Chairman Greenspan’s did, but it is remarkably similar in its intent and initial question: Governor Stein asks, “What factors lead to overheating episodes in credit markets?... Why is it that sometimes, things get out of balance?” Without mimicking Chairman Greenspan’s phrase, Governor Stein renews the quest, asking nearly a decade and a half later, “How do we know when irrational exuberance has unduly escalated asset values?”
I suppose it’s fair to criticize both queries on two grounds: 1) Although asked by Chairman Greenspan, it was never really answered in the 1996 speech. 2) If the Fed’s so smart, why are some of us still poor? Why did our 401(k)s become 201(k)s in 2009 before recovering to near peak levels currently? If they’re so smart, why the roller coaster ride, the 30% decline in home prices since 2006, and our current 7.9% unemployment rate?
Well to answer for the absent Chairman and the necessarily silent Governor Stein, the Fed incorrectly assumed that as long as inflation was benign, and future productivity prospects were near historical proportions, then asset price exuberance was an indirect and much less significant influence on economic growth. The Chairman admitted as much in a public “mea culpa” several years ago. We’re not that smart, he seemed to intone. Sometimes we make mistakes. I’m with you there, Mr. Chairman. Sometimes we all do.
So let’s approach this new paper with eyes wide open and pant bottoms close to those mythical musical chairs. Governor Stein’s speech reflects importantly on the answer to the question asked by a recent Wall Street Journal headline: “Is (the) Bull Sprint Becoming a Marathon?” Is there indeed “A Boom Time” in markets as the Financial Times queried on the heels of Dell, Virgin Media and then HJ Heinz?
Governor Stein, as does PIMCO, suggests caution. On a scale of 1-10 measuring asset price “irrationality,” we are probably at a 6 and moving in an upward direction. Admittedly, Stein never ventures into the netherworld of stock market prices or leveraged buyouts. He appears to know better. What he does stake claim to, however, is a thesis for high yield spreads with the implication that other credit markets bear similar consequences. His initial starting point is that the pricing of credit is primarily an institutional as opposed to a household decision making process. Individuals may become unduly irrational when it comes to buying high yield ETFs or mutual funds, but it is the banks, insurance companies and pension funds, to name the most dominant, that influence the price of credit — high yield bonds — and by osmosis, investment grade corporates, municipals, and other non-Treasury risk credit assets. From this initial premise, he then points to recent research by Harvard’s Robin Greenwood and Samuel Hanson that suggests that while credit spreads are helpful future guides, that a non-price measure — the new issue volume (and perhaps quality) of high yield bonds — is a more trustworthy input. To quote: “When the high-yield share (of issuance) is elevated, future returns on corporate credit tend to be low.” And because of financial innovation and easier regulatory changes, institutional buyers such as banks, insurance companies and pension funds tend to match the mountains of issuance with an exuberance that eventually can be labeled irrational. Stein’s bottomline is that recent evidence suggests that we are seeing a “fairly significant pattern of reaching-for-yield behavior emerging in corporate credit.” In fact, investors bought more than $100 billion of high yield and levered loan paper last year, a record level even exceeding the ominous levels in 2006 and 2007. Shown below in Chart 1 is a history of CLO issuance, admittedly a subset of high yield, but one which illustrates the supply pattern Governor Stein is leery of.