A report from the Department of Treasury’s Office of Financial Research indicates Market is Significantly Overvalued
For some time we have shared with our clients our concern that the stock market is overvalued. This concern is reinforced by the struggle the market has endured over the past five months. We believe the market has not been trading based on economic fundamentals. Factors such as the weakening dollar, foreign inflows, and corporate buybacks all come as a result of the massive liquidity injections by the Federal Reserve and other central banks, inflating asset prices to extreme valuation levels on a historic basis. The Federal Reserve’s discontinuation of its quantitative easing program in October 2014, has created economic headwinds with the probability of an increase in interest rates and a strengthening dollar. We believe that without the support of the Federal Reserve the market will continue to struggle.
The attached report from the Department of Treasury’s Office of Financial Research dated March 17, 2015 corroborates our views. The report has been quoted widely since its release, including in the Wall Street Journal, Financial Times, and Marketwatch.
The report notes that although extreme valuations in the stock market can persist for extended periods, high valuation levels usually imply higher risks and low or even negative returns in subsequent years. When the Federal Reserve embarked on Quantitative Easing in November 2008, the implicit assumption was that the appreciation in financial assets would trickle down and lift up the real economy. However, in retrospect, this policy has become a wedge between financial assets and the real economy. We believe that by removing this wedge, financial assets will be re-priced downward to reflect the underlining slow growth economy.
Many investors, especially those in or close to retirement, may want to consider under-allocating stocks at this point, as we believe there will be better opportunities to add risk to portfolios in the future. In any case, this would be a good time for all investors to review their portfolios to make sure their allocations are properly aligned with their investment horizon, tolerance for loss, and financial goals.