NEW YORK (MarketWatch) — Wall Street can’t say it hasn’t been warned.
The Office of Financial Research, the agency tasked with promoting financial stability and keeping an eye on markets, released a paper last week stating that the stock market is dangerously overpriced, and that excessive leverage will exacerbate the next market correction.
The paper is aptly titled “Quicksilver Markets” alluding to when prices deflate, it will happen swiftly and not without pain.
“The timing of market shocks is difficult, if not impossible, to identify in advance, let alone quantify — a shock, by definition, is unexpected,” wrote Ted Berg, an analyst at OFR.
But Berg identified several indicators that are pointing to a correction. Instead of looking at valuation in isolation, Berg and his team analyzed other factors, such as corporate profits and leverage, and found a disturbing picture.
He argued that forward price-to-earnings ratios are not very good predictors of market downturns, as they tend to be biased during boom times, but other metrics, such as the so-called CAPE ratio, Q-ratio and Buffett indicator all offer warning signs.
Just to provide a little context for the less technically minded market watchers, the CAPE ratio is the ratio of the S&P 500 index to trailing 10-year average earnings. Q-ratio is the market value of nonfinancial corporate equities outstanding divided by net worth, while the Buffett Indicator describes the ratio of corporate-market value to gross national product. All three of those metrics are approaching two standard deviations above historical means, while forward P/E ratios are within historical norms.
Translation: Stocks are way overvalued and companies’ earnings growth isn’t sustainable.
Office of Financial Research
Further number crunching pointed to negative returns when these indicator deviated sharply upward from their mean.
Office of Financial Research
Margin debt levels at half a trillion dollars at the end of 2014, as well as corporate debt levels estimated at $7.4 trillion are alarmingly high, argues Berg, saying “..forced sales of equities by large leveraged investors at the margin could be a catalyst that sparks a larger selloff”.
As to corporate leverage, debt proceeds have largely been used for stock buybacks, dividend increases, and mergers and acquisitions. “Once the cycle turns from expansion to downturn, the buildup of past excesses will eventually lead to future defaults and losses,” he writes.
So what about demand and appetite for equities because there are no alternatives? Well, that game of musical chairs will end eventually as “history shows high valuations carry inherent risk.”
There’s no question there will be a market correction of some sort, the paper concludes, and because of “leverage, compressed pricing of risk, interconnectedness” the risk for potential financial stability deserves further attention and analysis.
Watch out below!
Stocks are overpriced, overleveraged, headed for trouble – MarketWatch.
