Simultaneously high valuations in both stocks and bonds, an extremely unusual occurrence, threaten to give investors a "nasty shock" in the coming months, leading to a selloff in the S&P 500 (SPX) and Dow Jones Industrial Average (DJIA) as the Fed moves to normalize interest rates, according to market strategists cited by CNBC. A new research report from Deutsche Bank AG (DB) finds that worldwide asset prices are "possibly the most elevated" in history, per CNBC. Boris Schlossberg, managing director of foreign exchange strategy at BK Asset Management, concurs. He told CNBC that there is "gross overvaluation in both equities and bonds," and that investors should brace themselves as the Fed and other central banks reduce their massive balance sheets by trillions of dollars, which should send interest rates upwards.
The Next Financial Crisis
This scenario is presented in one part of the Deutsche Bank report called "The Next Financial Crisis," CNBC reports. The authors of the report looked at data from the year 1800 onwards related to the markets for both equities and government bonds in 15 developed countries. They derived an equal-weighted index which compared current bond yields to historical averages for each country, and current stock prices to nominal GDP in each country. Their conclusion: globally, both bond and equity prices are, on average, at historic high levels.
Source: Deutsche Bank, CNBC
In a commentary that he recorded for CNBC, Schlossberg says that while one might quibble with the specifics of Deutsche Bank's analytic method, he finds that "the conclusions are valid." Moreover, he indicates that this highly unusual development of simultaneous valuation bubbles in both equites and bonds is "the direct result of quantitative easing" by the Fed and other central banks around the world.
Inevitably, he concludes, this "will create a sell-off in one or both markets." Former Fed Chairman Alan Greenspan has offered similar views. (For more, see also: Stocks' Big Threat Is a Bond Collapse: Greenspan.)
As of Friday, trailing P/E ratios were 24.1 for the S&P 500 Index and 26.0 for the Nasdaq 100 Index (NDX), according to weekly analysis by Birinyi Associates reported by the Wall Street Journal. As of Tuesday, the figure was 20.5 for the Dow Jones Industrial Average, per the same sources.
Among the 30 Dow stocks, the loftiest in terms of current valuations are, based on trailing P/Es: soft drink maker Coca-Cola Co. (KO), 47.9; payments processor Visa Inc. (V), 40.5; drug maker Merck & Co. Inc. (MRK), 36.0; and oil giant Chevron Corp. (CVX), 37.7. When valuations get this high, they typically are indicative of rosy assumptions about future earnings.
Whether these earnings estimates actually come to fruition is another question. Additionally, the tendency of rapidly deflating valuations in one sector to bring down the market already has been demonstrated in recent memory. One example is the bursting of the technology, or dotcom, bubble in 2000. Another is the crisis among banking and brokerage firms in 2008 that sparked massive stock declines and the worst economic recession since World War II.