Last week, I was asked to comment on Martin Feldstein’s article in Wednesday’s edition of the Wall Street Journal (subscription required). In the article, Mr. Feldstein suggests that investors have been accepting higher levels of risk in their investments in a quest for higher returns. He holds that this means many assets are overpriced, and the Fed’s actions in raising interest rates will cause those prices to fall.
I agree that the Fed's zero interest rate and quantitative easing policies have led to inappropriate asset prices, in some cases, and that the stock market is fully valued, based on earnings. Debt-financed share buybacks have propped up earnings per share and valuations in the short term. Company balance sheets are significantly more leveraged even though debt service coverage ratios are favorable. That said, I don't think stocks are grossly overpriced, but natural volatility could push share prices of the S&P 500 Index to 1,600/1,700 levels this year (which might represent a good buying opportunity).
I do not agree with Feldstein’s assertion that the Fed can and should raise rates more rapidly and by a greater amount. The impact to the U.S. and global economy in this environment of global deflation would be swift and severe. At our most recent Investment Management Committee meeting, I asked the team their expectation for the number of Fed tightenings this year. The consensus was for two or less Fed tightenings this year versus the generally expected four. We even had several votes for no additional Fed rate increases. Unless we see sustainable wage pressure, I don't see the Fed raising interest rates at the pace the market expects in the short term.
Last week was a volatile week for the stock market with choppy market action that tested the August lows for the S&P 500 Index. If this level doesn't hold we could see more downside in the short term and possibly even test 1,800 this week for the S&P 500 Index. The catalyst needed to stop this slide in stocks remains elusive, but look for volume or sentiment indicators to signal a near-term bottom. With regards to the 10 year Treasury, it has pierced the 2% level as was mentioned last week. I think this is a reasonable level to be short bonds given the tremendous rally we have seen so far this year.
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