Equities are overvalued
Stocks are expensive using the most rudimentary of metrics; price.
Global stocks have posted significant gains in recent years and the bull run has been characterised by a severe lack of meaningful corrections and prices have drifted to record reach record highs on numerous occasions.
Major developed world indices currently reside mere percent away from all-time highs whilst the velocity of the gains is subsiding.
Now while bull markets do not die of old age, the longer stocks remain elevated, the closer we get to the next major sell-off.
Pulling up the bonnet of stock prices reveals further cause for caution. Stock index earnings multiples are well above historical averages and in some cases valuations are approaching the most expensive on record.
Historical 12-month trailing price-to-earnings in developed market equities are approaching the highest levels on record with ratios well above 20.
The last time valuations were this stretched was in the Dotcom bubble which ended in a global stock market crash.
Robert Shiller’s Cyclically Adjusted Price-to-Earnings Ratio (CAPE) of the S&P 500 is currently at 29, the same level as 1929’s Black Tuesday.
Central Banks are tightening monetary policy
The fact the central banks are tightening policy pays testament to the strength of the global economy and the process is not a historically a direct cause of a market selloff.
However, the chances of a policy mistake leading to a market crash is much higher now than any time in recent history given the unprecedented period of low rates and huge bond purchase programs distorting equity prices.
Global stocks market have enjoyed the liquidity provided by central banks and some attribute the higher than average valuations of equities to easy monetary policy perverting traditional equity risk discounting.
As this punch bowl is withdrawn it is conceivable that markets experience multiple compression as shares correct back to longer terms averages mentioned previously.
Volatility is at record lows
2017 has experienced the lowest levels of volatility for the longest periods on record.
Depending on who you ask, low volatility in markets is result of a combination of factors including low interest rates, a robust economy, the rise of passive ETFs and even Donald Trump.
Despite the apparent calm in markets many are worried the market is being complacent and this period of low volatility is the quiet before the storm of a sharp rise in volatility.
Broad-based selling
Low interest rates have forced investors into increasingly risky assets such as stocks in search of a yield.
This of course pushes up prices but many of these investors have opted for broad-based equity vehicles like ETFs which has lowered dispersion between individual stocks and added to the sense of tranquillity.
This however could prove to be a double edged sword as when investors start to leave the market through ETFs the selling could be indiscriminate and lead to liquidity issues and magnified volatility.
