By Rodrigo Campos and Caroline Valetkevitch
(Reuters) - The Federal Reserve on Tuesday voiced concern about stretched valuations in certain corners of the U.S. markets, including small cap, biotechnology and social media stocks, as well as the leveraged loan market.
The unusual comments from the Fed's monetary policy report - the first time in 14 years that the Fed has commented specifically on valuation of a particular equity sector - that accompanied Fed Chair Janet Yellen's semi-annual testimony to Congress, hit stocks in riskier sectors of the market.
Yellen said in remarks to the Senate Banking Committee that valuations across equity markets remain generally in line with long-term averages, but the Fed's report said the forward price-to-earnings multiples for smaller companies and those in the biotechnology and social media sectors appear "high relative to historical norms."
Well-known names such as Facebook, LinkedIn and Yelp slipped after the news. Shares of Yelp Inc were among the hardest hit, falling 2.8 percent to $69.14 a share, and the Nasdaq Biotech Index also fell, losing 1.6 percent.
"It's very unusual for the Fed chairman to take a micro view of a specific industry group. Usually the comments are very top level. So I think the Fed is a little more in tune with what has been bothering the market. My thought is it's late, but not too late in terms of recognition," said Fred Dickson, chief market strategist at D.A. Davidson & Co. in Lake Oswego, Oregon.
Last week the equity market weakened, with notable declines in small-cap names. The Russell 2000 has lost 4.6 percent in the last seven trading days, while the Nasdaq Biotech index is off by 4.8 percent.
Throughout 2013, social media and biotechnology shares were among the market's most popular names, posting massive gains as investors, particularly hedge funds, piled in. Meanwhile short-sellers who saw the stocks as overvalued were forced to reverse those bets as they lost money. The Global X Social Media ETF, which includes Facebook and LinkedIn among its holdings, rose 64 percent in 2013.
The gains occurred even as these stocks sport lofty price-to-earnings ratios that far surpass valuations of the broader index. While the benchmark Standard & Poor's 500 stock index has a forward P/E of about 15.5, Facebook's forward P/E is about 55 and Twitter is at 145.
Hedge funds were caught this year, when those stocks slumped in late February in a selloff that continued for several weeks. The stocks rebounded in June, but most have failed to attain earlier heights. The SOCL exchange-traded fund is down 11.4 percent in 2014.
“These are the sub-industries that have caused a lot of long time stock watchers to scratch their heads," said Kim Forrest, senior equity research analyst, Fort Pitt Capital Group in Pittsburgh.
"I’d say she’d like to deflate these bubbles with a little bit of stock talk.”
Also in the report, the Fed notes that issuance of "speculative-grade corporate bonds and leveraged loans has been very robust, and underwriting standards have loosened," with lower-rated issuers sporting higher debt-to-equity ratios.
The last mention of specific equity sectors appears in a Fed monetary policy report in July 2000, when it says that "growing unease about the lofty valuations reached by technology shares and rising default rates in the corporate sector may have given some investors a better appreciation of the risks of holding stocks in general.”
Art Hogan, chief market strategist at Wunderlich Securities in New York, said the comments also recall former Fed Chairman Alan Greenspan's statement in 1996 during a speech, when he asked whether "irrational exuberance has unduly escalated asset values," which sparked a brief selloff in stocks.
"Am I surprised? Absolutely! It’s off the script," Hogan said.
"It’s not what we’re used to and it’s certainly not something that we ever got from (former Fed Chair Ben) Bernanke."
(Reporting By Dan Burns, Rodrigo Campos, Herb Lash and Caroline Valetkevitch; Writing by David Gaffen; Editing by Chizu Nomiyama)