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.
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