DEUTSCHE BANK: 'Frothy' stock market valuations may present a problem

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Stocks in developed markets are beginning to show symptoms of “froth”, according to Mikihiro Matsuoka, chief Japan economist at Deutsche Bank, and with major central banks now in the process of removing policy stimulus or on the cusp of doing so, that could lead to substantial declines in the period ahead.

Matsuoka points to the chart below to justify why, in his opinion, market valuations are looking a little frothy at present.

Source: Deutsche Bank

It’s a simple average of the standard deviation of the stock market capitalisation as percentage of GDP of seven major developed countries — Australia, Canada, Germany, Japan, Switzerland, UK and the US — essentially measuring how it currently ranks compared to historic norms.

Matsuoka notes the current standard deviation — at 1.29 — is now approaching the levels seen during previous peaks of 2000 and 2008, a somewhat ominous signal on what may lie ahead given the scale of the declines seen following those previous peaks.

“The reason we believe it is entering a frothy territory is that an eventual turnaround of monetary policy after a long period of post-GFC accommodation is under way in major developed countries, which in our view, raises the returns on safe assets and lowers the valuation of risk assets,” he says.

And, as was the case when central bank stimulus was rolled out in response to the global financial crisis back in late 2008, Matsuoka believes initial moves to withdraw that stimulus could lead to the most pronounced losses.

“The first round of QE had a bigger impact on both the financial market and the real economy than the second and the third shots of quantitative easing (QE). It is because the financial market had to dramatically recalibrate its model of the resulting steady state after the introduction of QE,” he says.

“Likewise, the first round of the withdrawal of monetary accommodation could well deliver a bigger negative effect on the financial market and the real economy than the ensuing second and third shots of monetary policy turnaround.”

With the US Federal Reserve seemingly about to embark on balance sheet normalisation in conjunction with further rate hikes, and with the Bank of Canada, European Central Bank and Bank of England also signalling a potential reversal of previous monetary policy stimulus, it’s little wonder why Matsuoka and others are warning about what may lie ahead.

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