Perspective on High Valuations and a Volatile Stock Market
As we observe the financial markets and compare the relative attractiveness of different asset classes, we have drawn two main conclusions about current conditions.

Risk Has Increased: High valuations across all asset classes, along with the shift to monetary tightening, bring increased risk for investors.
We are in a period of high valuations across asset classes. We have had a massive market recovery since the Global Financial Crisis of 2008-2009. From the perspective of where valuations have been over the past 100 years, we are now in the most expensive valuation decile for both stocks and U.S. Treasuries. It is an unusual situation to have stocks and bonds be expensive at the same time. Normally, one offers some value versus the other. In the late 1990s, stocks were expensive, while Treasuries offered better value. In the 1940s, in the aftermath of the Great Depression, Treasuries were expensive, but stocks offered good value. In 1980 and 1981, both stocks and Treasuries had low valuations, and that set the stage for the 30-year bull market we’ve seen with both stocks and bonds.

We believe there is a significant risk in the markets for investors when valuations are at these high levels. While it is virtually impossible to predict what might happen over a one-year period, the historical evidence demonstrates that valuation does impact the subsequent returns that investors can expect over long periods, such as 5 to 10 years.

These high valuations are present at a time when we are seeing a regime shift. After the financial crisis, the U.S. Federal Reserve and other central banks around the world were in an extended easing regime. Now the Fed is entering a tightening phase, as it looks to reduce its balance sheet.

Europe has started to reduce its quantitative easing as well. If we get into a situation in which the regime of central bank easing has ended, that shift – along with high asset valuations – could change the market environment substantially.

Exhibit 1: Current Equity and Fixed Income Valuations Appear Expensive Relative to History

Volatility may continue: A worrisome jobs report provided the initial spark, while volatility-targeting funds added fuel to the fire. Now fear of a trade war is making the increased volatility persist.

Before examining the causes of the market’s recent selloff, it is important to consider the context in which it occurred. By the end of 2017, we had gone 381 days without a drawdown on the S&P 500 of 5% of more. Usually, the S&P 500 has a drawdown of that magnitude every 90 days. In that light, one might consider this recent drawdown as more than four times overdue.

This prolonged period of low volatility may have bred some complacency and a lack of concern about downside volatility.

There were a couple of sparks that seemed to have ignited what happened. The first was a January payroll report, which showed accelerating wages in the United States. That made U.S. interest rates move sharply higher and that, in turn, led to the selloff in U.S. equities.

Additional factors contributed to the speed and scale of the selloff. The first was high valuations. The second was the type of investors now in the market. We have seen an increase in risk-averse investors. They move quickly to de-risk as volatility increases, and their reaction can increase the speed with which these drawdowns occur.

The market was caught off guard. Managed futures funds, which did great during the financial crisis, were down 8% (as measured by the Morningstar Category Index), a big loss for these types of funds. One prominent risk-parity fund was down more than 11% -- even more than the S&P 500’s decline of 10% more -- because of the leverage that risk-parity funds employ.

Subsequently, fears of a trade war between the United States and other countries have sparked another round of market volatility. It will take some time for the outcome to be determined but regardless of the outcome the risks are elevated. 

In our view, we are likely entering a period of more normal market volatility, if not elevated levels, given the current backdrop.

The Shiller CAPE Ratio is a valuation measure usually applied to the US S&P 500 equity market. It is defined as price divided by the average of 10 years of earnings (moving average), adjusted for inflation.

The S&P 500® Index is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries within the U.S. economy the index includes reinvestment of dividends but does not include fees, expenses, or taxes.