Goldman Sachs warns of highest valuations since 1900
December 13, 2017
A prolonged bull market across (Anglosphere - BB) stocks, bonds and credit has left a measure of average valuation at the highest since 1900, a condition that at some point is going to translate into pain for investors, according to Goldman Sachs Group. "It has seldom been the case that equities, bonds and credit have been similarly expensive at the same time, only in the Roaring '20s and the Golden '50s," Goldman Sachs International strategists including Christian Mueller-Glissman wrote in a note this week. "All good things must come to an end" and "there will be a bear market, eventually" they said.
"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.
Warnings on elevated asset prices have become more frequent as the world’s biggest central banks move toward tighter monetary policy.
“Ultimately, the fate of nearly all asset classes appeared to hinge on the evolution of government bond yields,” the Basel, Switzerland-based institution said. “There is also significant uncertainty about the levels those yields will reach once monetary policies are normalized in the core jurisdictions.”
Rather it (BIS) said bond-market yields show even more froth than stocks, based on historical standards.
“Postponing normalization too much also has risks,” Jaime Caruana ( https://en.wikipedia.org/wiki/Jaime_Caruana ) said in an interview. “Why? Because there is more risk-taking and it’s difficult to know where the risk-taking will go.”
A bond market bubble is the biggest threat to stock prices right now, former Federal Reserve Chairman Alan Greenspan warns in a Bloomberg interview. Greenspan's comment is bound to surprise nervous equity market observers who, instead, have been focusing intently on historically high valuations, narrow market leadership, unusually low volatility and other indications of undue complacency among investors.
"By any measure, real long-term interest rates are much too low and therefore unsustainable. When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace," Greenspan comments to Bloomberg.
When central banks start withdrawing liquidity from the financial system in earnest by selling their bond holdings, Greenspan believes that long term interest rates will spring sharply upwards. Thus, bond prices will collapse. Greenspan says that would lead to the worst bout of stagflation since the 1970s, a period when inflation accelerated amid a stagnating U.S. economy. This environment would spark a nosedive in stock prices, Greenspan continues, because sharply higher bond yields could spur a massive movement of investor capital from equities to fixed income instruments.