Yellen Shows She Might Not Understand When Bubbles Are Dangerous

Wednesday, 23 Jul 2014 07:31 AM

By Michael Carr

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Federal Reserve chairs have made occasional stock market forecasts. Famously, Alan Greenspan worried that stock prices were displaying signs of irrational exuberance more than three years before the Internet bubble led to a market crash.

Last week, Janet Yellen noted that “valuation metrics in some sectors do appear substantially stretched, particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.”

Social media stocks are overvalued with 10 of the largest companies having an average price-to-earnings ratio of 77.

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When the bubble bursts in social media it will have a small impact on investors. The combined market cap of the largest companies in the sector is less than the value of Apple or Exxon Mobil.

The argument that the biotech sector is overvalued is less clear cut. SPDR S&P Biotech ETF, a proxy for the sector, has a price-to-earnings ratio of 35, high but nowhere near the level seen in previous bubbles.

These are relatively small sectors and investors in these stocks are most likely more aggressive than average. Bubbles are only a concern when they affect almost all investors. Widespread home ownership was responsible for the devastating impact of the real estate bubble. The Internet bubble in 2000 led to a bear market in stocks because technology represented 20 percent of the market’s value.

The stock market can withstand declines in social media and biotech stocks. Investors will suffer more harm from the bubble that’s been created in money supply that Yellen is partly responsible for. While her stock market insights are interesting, her views on how to avoid a bubble in monetary policy would be more important.

Editor’s Note: New Warning - Stocks on Verge of Major Collapse

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