The Fed is Warning Wall Street on Valuations

Market valuations for several assets are getting stretched by historical standards, according to the Fed’s November 2021 Financial Stability Report.

“Across most asset classes, valuation measures are high relative to historical norms,” says the report, which was released on Monday. “Since the May 2021 Financial Stability Report, equity prices rose further. While this increase is due, in part, to improved earnings expectations, the ratio of prices to forecasts of corporate earnings stands at the upper end of its historical distribution.”

What Keeps Valuations High

There’s a good reason for stretched valuations. Yields on long-term Treasury securities, corporate bonds, and leveraged loans remain at low levels relative to their historical ranges, as the report indicates. That’s due to the Fed’s accommodative monetary policies launched at the beginning of the pandemic, though the pandemic is receding.

Investor Risks Moderate

While valuations remain extended compared to its last report, the Fed sees investors moderating their risk appetites. This is evidenced by the increase in the difference between the forward earnings-to-price ratio and the expected real yield on 10-year Treasury securities (equity premium).

“In contrast to the signal from other valuation measures, this measure of the equity premium remained somewhat above its median, suggesting that equity investor risk appetite remained within historical norms,” says the report.

Asset Prices Are Vulnerable to a Correction

Still, asset prices are susceptible to a correction. “Asset prices remain vulnerable to significant declines should investor risk sentiment deteriorate, progress on containing the virus disappoint, or the economic recovery stall,” says the report.

The Fed’s warning to investors about valuations sounds like former Fed chair Alan Greenspan in his famous 1996 speech, “The Challenge of Central Banking in a Democratic Society,” where he warned investors of irrational exuberance.

“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And, how do we factor that assessment into monetary policy?”

That’s something Fed officials must figure out in the face of elevated inflation, which has made investors rethink current market valuations.

Disclaimer: The information contained in this article represents the views and opinion of the writer only, and not the views or opinion of TipRanks or its affiliates, and should be considered for informational purposes only. TipRanks makes no warranties about the completeness, accuracy or reliability of such information. Nothing in this article should be taken as a recommendation or solicitation to purchase or sell securities. Nothing in the article constitutes legal, professional, investment and/or financial advice and/or takes into account the specific needs and/or requirements of an individual, nor does any information in the article constitute a comprehensive or complete statement of the matters or subject discussed therein. TipRanks and its affiliates disclaim all liability or responsibility with respect to the content of the article, and any action taken upon the information in the article is at your own and sole risk. The link to this article does not constitute an endorsement or recommendation by TipRanks or its affiliates. Past performance is not indicative of future results, prices or performance.