Office of Financial Research: high valuations and high debt levels pose risks
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 while excessive leverage will exacerbate the next market correction.Here's Quicksilver Markets (9 page PDF), here's the Office of Financial Research homepage and here is the OFR's Director.
The paper is aptly titled “Quicksilver Markets” alluding that 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 offer 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....MORE
