Moody’s: Bonds And Stocks Overvalued, Watch Out For Liquidity Event

On yet another positive day for the stock market in the face of major macro headwinds from French elections to war with North Korea and potential for compromise not to be reached on a budget deal, there are two separate issues that will likely tear down the bull market run, a Moody’s report noted. One of those events would have bond yields rising slightly above levels seen this past March 6, 2017.

Stocks overvalued based on several historical revenue standards

“Stocks are not cheap,” Moody’s Chief Economist John Lonski, wrote in the firm’s weekly market analysis. Noting that “US equities remain untenably overvalued,” Lonski is looking for the next shoe to drop. 

In an April 6 research piece titled “Bond Yields Will Fall When the Equity Bubble Bursts,” Moody’s notes the multiple paid on pretax profits from current production was a level “unheard of prior to 1998.

One of two issues that concerns Lonski is the ratio of the market value of US stocks to yearlong pretax operating profits. This rose to 11.5:1 in in the fourth quarter of 2016, marking the highest such ratio since the second quarter in 2002 when a 12.5:1, immediately following the “tech wreck” stock market crash of 2001.

The average ratio is 14.8:1, achieved in 1999, just prior to the equity market’s value climbed to a record 17.3-times profits in the third quarter of 2000.

But that is not all. Stocks are expensive on several levels, including relative to corporate revenues.

Lonski noted as of the second quarter 2015, the market value of US stocks rose to a cycle high of 218% of corporate gross-value-added, a proxy for total corporate revenues. Second-quarter 2015’s ratio for the market value of common equity to corporate gross-value-added (GVA) was the highest since the 225% of third quarter 2000 just after equity valuations peaked at a record high 231%. During 2002-2007’s business cycle upturn the ratio failed to reach 200% and the market value of common stock reached a high of 185% of corporate GVA in the second quarter of 2007.

“Today’s very high valuation of equities vis-a-vis both profits and revenues does not preclude even richer share prices, but it does warn of substantially lower valuations in the event of an adverse shock,” Lonski wrote. “A deep drop by equity prices will quickly prompt a ballooning of high-yield bond spreads, which currently undercompensate for long-term default risk.”

The consensus on interest rates is wrong… again

In addition to stocks being overvalued, bonds and the consensus outlook on interest rates appears to contradict fundamentals.

Markets are looking for a calm, steady climb in interest rates, Lonski observes. The three-month Treasury bill rate is expected to climb from 0.80% to 2.0% by the fourth quarter of 2018, while the 10-year Treasury noted is expected to move from 2.37% to 3.3%.

“These forecasts implicitly assume that the equity bubble will not burst into 2018’s final quarter,” the Moody’s report noted with a degree of disbelief. “In other words, the consensus senses that the considerable downside risk of an overvalued equity market will not be realized, notwithstanding the projected return of a quarter-long average of more than 3% for the 10-year Treasury yield for the first time since Q2-2011’s 3.21%.”

Ultimately this won’t last and the consensus will be proven wrong again. “Not only did the consensus exaggerate business activity’s forthcoming pace, the consensus also extrapolated too much about future inflation from mid-2011’s speeding up of consumer price inflation,” Lonski wrote. “An eventual bursting of the equity bubble will diminish systemic liquidity.”

This will result in ”much costlier financial capital will prompt an increase in defaults,” as loan covenants tighten and the liquidation of business assets could occur to “provide badly needed relief to distressed borrowers.”