Federal Reserve to Entrepreneurs: Party Like It's 1999 (While You Still Can)
Federal Reserve Chairwoman Janet Yellen's first press conference yesterday sent markets into a tailspin after she suggested interest rates might rise once the Fed has finished with its multi-billion dollar bond repurchase program later this year.
Her comments renewed speculation that the stock market, in particular technology stocks, are way overvalued, approaching the "irrational exuberance" of the 1990s when Dotcom stocks were so inflated, they eventually burst, after the Fed raised interest rates.
Chances are your company isn't public, but as the saying goes, a rising tide floats all boats. The reverse is also true--low tides tend to sink all ships. Rising interest rates could cause a rapid stock market decline, in part because it would be more expensive to borrow to fund operations or expansion. But this is not 1999.
Whether it's Russia annexing Crimea, or the Fed hinting at an interest rate increase, history doesn't really repeat itself, so much as poorly mimic things that have come before. And that's particularly true with economics, which is half art and half science.
"Applying theories developed to describe how the economy worked in 1920 is probably not a great idea for fixing the economy in 2014," says economist John R. Dunham, managing partner of John Dunham and Associates in New York.
Low interest rates certainly drove a speculative bubble in Internet stocks in the 1990s under Federal Reserve Chairman Alan Greenspan, but the run-up was caused by individual investors, more than the Fed, Dunham says.
Again, in the early 2000s, the low rates maintained by the Fed helped to inflate an even more dangerous mortgage bubble manipulated by complex derivatives, banks, and unwary consumers.
What Goes Up...
Now the stock market appears to be headed into record territory once more--by some estimates average stock values are 60 percent higher than historic ranges say they should be--but that has always been part of the Fed's plan.
Quantitative easing, the monetary policy used to try to resolve the credit and monetary supply emergency caused by the Great Recession, included buying bonds to increase the availability of cash. It also helped keep interest rates low by raising the prices of the bonds being purchased.
High bond prices, in turn, have led investors to seek higher returns in riskier investments such as stocks.
"With such low rates persisting for so many years, market forces have driven dollars en masse toward equity, resulting in soaring valuations," says Jonathan Citrin, founder and chairman of investment advisory Citrin Group, in Birmingham, Michigan. "Without doubt, investors have flocked to technology over the past years, while global stock markets ran away from fundamentals."
The Fed is now trying to extricate itself from its hyper-involvement in monetary policy, for example by paring back its bond purchases to to $55 billion from $80 billion per month.
"It seems that even the Fed understands that their policies are underpinning the bubble and they are at a loss to figure out how to get out from under this without a market crash," Dunham says.
No one knows what could trigger a stock market crash--it could be geopolitical unrest such as events with Russia and Crimea, or a spike in interest rates at home, or even something commodity driven, like an oil shock, experts say.
But one thing's certain--a drop in stock market value will also affect your business. Granted, the recovery has not been so broad based to begin with. The wealthy have benefitted most from the rebound. A record number of people are still unemployed, and indications are that small business sales are beginning to slow again.
Add falling stock prices and things could get pretty bleak for small businesses. As an example of how that could work, Ross Fubini, a partner at Canaan Partners, of San Francisco, says one need only examine Facebook's recent record acquisition of WhatsApp for $19 billion. With a high-flying stock near $70 a share, Facebook is able to finance the purchase from 8 percent of its outstanding stock. A sudden decline in stock prices would also push down the amount of money large companies are willing to pay for startups.
"Unfortunately, companies will get hurt, the exacerbation of valuations to the upside may be mirrored to the same degree on the downside once the ball starts rolling," Citrin says.