When referring to equity market valuations in a 1996 speech at the American Enterprise Institute, former Federal Reserve Chairman Alan Greenspan famously uttered the phrase "irrational exuberance." That phrase has become part of the popular lexicon and has been applied in many other contexts to describe overenthusiastic or unbridled expectations.
Many market analysts believe that we may be approaching irrational exuberance regarding expectations for the Trump administration to foster a stronger economy. This is illustrated by the willingness of fixed-income investors to accept lower and lower yields on high-risk bonds. The readiness of investors to accept greater levels of risk to achieve yield targets -- reaching for yield -- is one of the most dangerous signs the market may be overvalued.
A recent Financial Times article showed that the spread between benchmark Treasury bond yields and the yields on junk bonds has fallen to about 400 basis points from more than 800 basis points about a year ago. Additionally, that same article shows that the yield on corporate bonds with ratings of triple-C-plus or lower has fallen toward 10%. That same class of bonds was yielding nearly 22% in early 2016. As junk bonds are really a hybrid security -- that is, part bond and part equity -- investors are buying into a dramatic economic improvement in the coming years.
Investors may also be ignoring the potential impact of higher inflation on market valuations. The Federal Reserve has indicated that the market should expect three 25-basis-point rate hikes in 2017. Rising interest rates, coupled with lower tax receipts as a result of anticipated tax cuts, could lead to increases in the federal debt and large budget deficits because of higher interest payments on that debt.
Seth Klarman recently wrote a private letter to his investors describing his view that there are "perilously high valuations" in the stock market. He also warned that Trump's protectionist moves carry risks and that stimulative measures by the administration could boost inflation.
So, who is Seth Klarman, and why should we value his opinion? Well, he runs the Baupost Group hedge fund, which manages some $30 billion. Mr. Klarman has an incredible track record as an investor. He has lost money in only three of the past 34 years, The New York Times notes. For context, even Warren Buffett's Berkshire Hathaway has suffered losses in seven of those 34 years.
Back in the fall of 1992, a student in a course I was teaching at Creighton University asked guest speaker Warren Buffett which young investment professionals had impressed him and who might be the next Buffett. The Oracle of Omaha replied without hesitation, "Seth Klarman."
Buffett famously said "be greedy when others are fearful and fearful when others are greedy." Perhaps the pendulum has swung and it is time to be a little more fearful and a little less greedy. That doesn't necessarily mean, however, that one should sell completely out of stocks and go to cash anticipating a dramatic market drop.