WASHINGTON -- Some analysts say they're not worried about stock and bond prices being pumped up artificially by the hordes of yield-hungry investors rushing to put their bank savings into mutual funds.
The issue came up again last week, when Federal Reserve officials said they are keeping an eye on the situation.
Members of the Shadow Open Market Committee, a private group of economists critical of Fed policy. warned last week that the central bank has been supplying too much liquidity to the banking system. The money draining out of banks into stock and bond funds is creating a price "bubble" that will eventually pop for disappointed investors, the panel warned.
According to the Investment Company Institute, the trade association for the mutual fund industry, in the first six months of the year investors poured more than $60 billion into stock and bond funds, up 23% from some $49 billion during the same period last year. In July alone, mutual funds netted nearly $13 billion.
There is little argument among economists that the Fed's policy of lowering short-term rates has been a chief factor behind the mutual fund bonanza at the expense of banks. Federal Reserve Board governor John LaWare, in an interview published last week by The Bond Buyer, noted that some banks are only paying 1 1/2% to 2% on demand deposits.
Federal Reserve vice chairman David Mullins, in interviews with Reuters and The New York Times, frankly admitted that Fed officials are worried that any further cuts in interest rates would only add to the stampede into stock and bond markets. Mullins went out of his way to insist, however, that he does not believe markets are overvalued.
So the comments coming out of the Fed were a typical mix of caution combined with reassurances that markets are not out of whack.
It is tempting to believe that the Fed's accommodative monetary policy could have unintended repurcussions for stocks and bonds. The central bank has kept the federal funds rate for banks unchanged at 3% for more than a year. And the monetary base, which consists of currency and bank reserves, has been expanding at over 11% during the past year.
But there are strong reasons to believe stocks are not overpriced given current bond yields, says Roger Brinner, executive. research director for Dri/McGraw-Hill Inc.
Brinner bases his conclusion on a comparison of current bond yields and price/earnings ratios, or the ratio of a stock's price to its earnings. He notes that an investor in a 10-year bond currently gets a yield of about 5.40%, which he says is consistent with the current price/earnings ratio of about 23 on the Standard and Poor's 500 Composite index.
"I don't think stocks are overvalued given current bond yields. If anything, they may be undervalued. but I do point out there is a risk of higher yields," said Brinner.
He calculates that a rise of half a percentage point, or 50 basis points, in the 10-year bond could trigger an 11% correction in stocks. That would especially be the case if inflationary fears rise while the economic outlook stays unchanged, he says.
On the other hand, Brinner says higher bond yields might not jar the stock market if they are based on expectations of improved growth and corporate earnings in a stronger U.S. and global economy.
James W. Coons, chief economist with Huntington National Bank in Columbus, says he is optimistic that low inflation will keep bond yields from rising much. He suggests the yield on the Treasury long bond might rise to 6 1/2% from 6% by the end of the year. "I don't expect to see the bursting of a speculative bubble that will push yields subtantially higher." he said.