Prolonged bull markets have pushed stocks, bonds and credit to their highest average valuation since 1900, raising the odds that the next bear market will be particularly severe, according to research by Goldman Sachs Group Inc. (GS), as reported by Bloomberg. This rare concurrence of valuation peaks has only been seen twice before in the U.S. since 1900, in the 1920s and in the 1950s, Goldman indicated. From such high valuations, "there is less buffer to absorb shocks," thus increasing the risk of severe price drops in response to bad news, Goldman said in note released last week, as quoted by Bloomberg.
To measure stock market valuation, Goldman used the cyclically-adjusted P/E ratio, also known as the CAPE ratio or the Shiller P/E ratio after its developer, Nobel Laureate in Economics Robert Shiller of Yale University. The CAPE smooths short-term fluctuations in valuations by comparing current stock prices to average earnings over the prior ten years. (For more, see also: Reading the CAPE Ratio for Booms, Busts, and Bubbles.)
For bonds, they looked at the yield on 10-Year U.S. Treasury Notes. To measure the cost of credit, they calculated the average yield spread between bonds of AAA quality, the highest grade, with those judged to be BBB or Baa, the lowest investment-grade rating. The narrower this spread is, the less investors are being compensated to take on the additional risk, and the cheaper credit has become.
Next, Goldman ranked all the observations in all three categories since 1900. The higher the CAPE ratio, the higher stock valuations are. The lower the T-Note yield, the higher bond valuations are. The lower the credit spread is, the higher credit valuations are for the purposes of this analysis.
On average, all three valuation measures are now within the highest 10% of readings that they have registered since 1900, per Goldman. This is a first, Bloomberg adds.
'Frothy' Stock and Bond Markets
The Bank for International Settlements (BIS), often characterized as the central bank for central banks, issued its own report on Sunday, making points that support Goldman's, per another Bloomberg story. They warn that stock prices worldwide, and especially in the U.S., look "frothy." The BIS worries that the CAPE ratio for U.S. stocks, recently at 30, is about 25% higher than its post-1982 average, and almost twice its longer-term average from 1881 to 2017. The BIS also noted, per Bloomberg, that U.K. and European stock valuations are also above their post-1982 averages.
Moreover, the BIS finds that the overvaluation in bonds is even worse than in stocks, Bloomberg adds, the result of loose monetary policies by central banks globally. This same concern has been voiced by former Federal Reserve Chairman Alan Greenspan, among others. (For more, see also: Stocks' Big Threat Is a Bond Collapse: Greenspan.)
The simultaneous valuation peaks today are occurring against a backdrop of low inflation, which also characterized the 1920s and the 1950s, Goldman indicates. High and rising inflation would hurt both stock and bond prices, they add. Meanwhile, concerns about price pressures would spur the Federal Reserve to raise interest rates, creating yet more downward pressure on asset prices, they warn.
Even absent a burst of inflation, central banks around the world have pledged to unwind their balance sheets, slowing reversing their concerted and prolonged period of quantitative easing that has pushed interest rates and credit spreads downward. As rates rise, asset values will sink, reducing returns. In a less likely scenario that Goldman calls "fast pain," this unwinding will occur swiftly, with severe shocks to both stock and bond valuations.
In any case, Goldman actually recommends increasing equity investments at this time, given their higher risk-adjusted returns than bonds, while moving to shorter maturities in bonds. Moreover, they indicate that bonds are becoming less useful as hedges for equities. A report from giant fixed income management firm PIMCO cited by Bloomberg echoes this concern, observing that central banks have driven interest rates so low, even into negative territory, that they have limited ability to buffer future growth or inflationary shocks, even if they wanted to.
Goldman calculates that major draw downs over the past century have imposed an average inflation-adjusted loss of 26% in a theoretic portfolio that is 60% stocks and 40% bonds. Additionally, as reported by Bloomberg, the decline is of 19 months' duration, and it takes an additional 24 months to get back to the previous peaks, on average.