Taking history as a lesson, the current situation of the US stock market is not very good, is the turning point not far away?

In its report on November 18, Deutsche Bank analyzed the similarities between the current market environment and three historical highs: the late 1990s Internet bubble, the market peak before the global financial crisis in 2007, and the market prosperity in 2021.

Risk assets have performed well in the past 18 months, but the valuations of various asset classes are already at high levels. The cyclically adjusted price-to-earnings ratio (CAPE) of the S&P 500 has only exceeded the current level twice in the past century.

This has raised concerns about the similarities between the current market environment and three historically high valuation periods. In all three cases, due to already high valuations, there is little room for further upside, leading to significant corrections afterwards.

Specifically:

1. Late 1990s Internet bubble: During this period, the stock market continued to rise, with the S&P 500 tripling in five years. However, with valuations becoming too high, the market experienced three consecutive years of decline from 2000 to 2002, the only time since World War II.

The similarities between the current market and that time include: the expected annual growth rate of the S&P 500 to exceed 20% for two consecutive years, both the Federal Reserve's loose monetary policy then and now, and the market being primarily driven by a few technology stocks.

It is worth mentioning that the internet bubble has also well proven that even with initially high valuations, relentless increases can continue for a period of time. When the CAPE ratio reached the current level in early 1998, the market still rose for another two years, high valuation markets may still continue for a period of time until catalytic factors such as economic slowdown appear to end the rise.

2. On the eve of the 2007 global financial crisis: Prior to the first global financial crisis, the market performed well, with the S&P 500 surpassing its 2000 record in May 2007, and the volatility was also low.

The current market also exhibits similar characteristics, such as very tight credit spreads (the credit spread of high-yield bonds in the United States is at its lowest level since 2007). In addition, prolonged stability may lead to risk accumulation and complacency, potentially laying the groundwork for the next financial instability.

3. Market prosperity in 2021: Due to stimulus measures from the COVID-19 pandemic, U.S. risk assets rebounded strongly at the end of 2021, however, valuations across multiple asset classes have been increasingly high. By November 2021, signs of market turnaround emerged, with Nasdaq and Bitcoin reaching their peaks in the same month. Federal Reserve Chairman Powell confirmed that high inflation was not transitory at that time, followed by a shift in Fed policy to be more hawkish. With high inflation persisting in 2022 and worsening economic growth, the market experienced continued selling pressure, with the S&P 500 index falling more than 25% from its peak in January 2022 to a low point in October. In addition, the 10-year Treasury yield rose by 236 basis points overall in 2022, marking the largest annual increase since 1788.

Overall, the Deutsche Bank report summarized as follows:

Historically, examples of high return often come with significant reversals. In the two examples, after the CAPE ratio reached the current high levels, there were significant adjustments. When market valuations are too high, the potential for further increase may be limited, and the turning point may come quickly. Investors need to pay attention to market valuation levels and be vigilant against potential market adjustment risks brought on by economic slowdown or other catalytic factors.

Editor/Lambor