ANOTHER week, another wave of soaring stock markets. The Nasdaq topped 5,000, nearing an all-time high, after the US Federal Reserve indicated that monetary tightening will proceed slower than investors had feared. That prompted other global stock indices to jump, as investors also took comfort from the fact that the European Central Bank is unleashing its own quantitative easing.

But before anyone gets too thrilled about equities, they should read a sobering research document from a corner of the US Treasury known as the Office of Financial Research.

Ted Berg, an OFR analyst, has studied the history of American stock markets, and concludes the S&P 500 is nearing a ‘two sigma’ (or two standard) deviation from the historic norm. In plain English, his charts imply that markets are in bubble territory, comparable to patterns seen in 1929, 2000 and 2007.

The indication, then, is that a big correction-cum-crash looms; indeed, Mr Berg thinks the situation is so fragile that the OFR report has the provocative title Quicksilver Markets. And, as Mr Berg says: “Quicksilver markets can turn from tranquil to turbulent in short order.” He draws parallels with 2006.

Investors should keep a close eye on the OFR. It was created under the Dodd-Frank Act that followed the 2008 financial crisis, with a mandate to monitor threats to financial stability. It seemed the OFR would be a boring, data-gathering body.

The markets are in bubble territory, comparable to patterns seen in 1929, 2000 and 2007, according to a study by Ted Berg, an Office of Financial Research analyst

This year, however, the OFR started publishing freethinking research that challenges the orthodoxy of other government bodies in Washington. Earlier this month, for example, one of its economists cheekily questioned the value of the Fed’s bank stress tests — just before the stress-test results were announced. The release of the Quicksilver Markets report on the eve of the press conference given by Janet Yellen, Fed chair, following the central bank’s latest statement seems to be in a similar (cheeky) vein.

The fact that the OFR is speaking up is potentially useful for parts of the Washington government. Back in 2006 and 2007, as credit and equity markets soared, many policymakers were privately nervous about the bubbles. But almost nobody dared to ring alarm bells, for fear of setting off a crash.

This time around, some policy makers are still nervous of speaking too openly about bubbles (not least because an explicit goal of quantitative easing has been to raise asset prices). Others are convinced that the bureaucracy needs to learn the lessons of 2006, and speak up. One way to make sense of the messages emanating from the OFR is that they create a paper trail for Washington officials that might be useful in a senate hearing in few years’ time. Nobody can say they were not warned.

But the most important point is that, if Mr Berg’s analysis is correct, many investors need to rethink how they evaluate equities. When main street analysts judge whether equity markets are fairly valued, they typically use the price-to-earnings ratio. On this measure, US stock markets do not look so wildly expensive and many retail investors continue to pour cash into equities.

Mr Berg suggests that it is wrong to rely on the PE ratio, since it is distorted by analyst optimism and low interest rates. He prefers to use other measures, such as the ‘Cape’ ratio (a cyclically adjusted PE ratio), Q-ratio (a measure that focuses on non-financial companies) or the so-called ‘Buffett index’ (a measure of corporate market value to gross national product favoured by Warren Buffett).

Those measures may be as flawed as that PE ratio. However, the point to note from Mr Berg’s paper is that all three of these alternative measures suggest equity valuations are extreme by historical standards. This does not tell us when the turning point might occur but Mr Berg wants investors and policymakers to focus on the risks of a 2000-style crash, particularly if it breeds contagion.

Thankfully, some investors are listening. This week Bank of America Merrill Lynch released a survey of fund managers that showed that a net 6pc of global asset allocators were overweight in US equities in February, but now 19pc are underweight. It is a remarkable swing in a short space of time, and has created ‘the biggest underweight since January 2008’, the bank notes.

Yet the people who really need to take note of the Quicksilver report should be the retail investors who keep jumping into stocks. And, of course, those western central bankers who keep pumping up the equity markets. Perhaps a copy should be placed on Ms Yellen’s desk.

gillian.tett@ft.com

Published in Dawn, Economic & Business, March 23rd , 2015

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