OFFICE OF FINANCIAL RESEARCH

BRIEF

SERIES

Views and opinions are those of the author and do not necessarily represent official positions or policy of the OFR or Treasury. OFR reports 

may be quoted without additional permission.

Quicksilver Markets

by Ted Berg

One of the missions of the Office of Financial Research is to analyze asset market valuations 

and if there are excesses, explore the potential financial stability ramifications of a sharp 

correction. The author argues that U.S. stock prices today appear high by historical standards. 

Although he notes that the financial stability implications of a market correction could be 

moderate due to limited liquidity transformation in equity markets, he addresses other 

financial stability issues that may be more relevant, such as leverage, compressed pricing of 

risk, interconnectedness, and complexity. 

15-02 | March 17, 2015

Option-implied volatility is quite low today, but markets can change rapidly and unpredictably, a phenomenon

described here as “quicksilver markets.” The volatility spikes 

in late 2014 and early 2015 may foreshadow more turbulent 

times ahead. Although no one can predict the timing of market 

shocks, we can identify periods when asset prices appear abnormally high, and we can address the potential implications for 

financial stability.

 The bull market achieved an important milestone in March: its 

six-year anniversary. From the market bottom in March 2009 

through the end of 2014, U.S. equity prices tripled. This gain 

has been largely driven by the recovery in corporate earnings, 

which have increased by a similar magnitude over this period. 

Although the positive trend could continue, the upturn has 

persisted much longer and prices have risen much higher than 

most historical bull markets, despite a weaker-than-normal 

macroeconomic recovery (see Figure 1). 

Figure 1. Current Bull Market Is Longer and Larger than Historical Bull Markets

600

1,000

1,400

1,800

2,200

2006 2007 2008 2009 2010 2011 2012 2013 2014

S&P 500 closing prices

Sources: Bloomberg L.P., OFR analysis

Peak: Oct 9, 2007 (1565)

57%

drop

Trough: Mar 9, 2009 (677)

0

100

200

300

400

500

0 20 40 60 80 100 120

Historical bull markets (1932 to present)

Sources: S&P Dow Jones Indices, Byron Wien (Blackstone), OFR analysis

Price advance (percent)

Duraon (months)

10/90 - 3/00

6/32 - 3/37

6/49 - 8/56

8/82 - 8/87

3/09 - Present

(72 months, 211%) -

10/74 - 11/80

4/42 - 5/56

10/02 - 10/07

10/66 -11/68

5/70 -1/73

12/87 -7/90

6/62 -2/66

10/57 - 12/61

Average

(57 months, 165%)
OFR Brief Series March 2015 | Page 2

This bull market has also benefited from unusually low interest rates. Some argue that the market’s price-to-earnings (PE) 

ratio is justifiably higher than the historical average given that 

interest rates are at historic lows. After all, the intrinsic value of 

a stock is the present value of its discounted future cash flows. 

And interest rates are a key factor in determining the discount 

rate. The lower the discount rate, the higher a stock’s present 

value. However, the relationship between interest rates and 

stock prices is more complex; a lower interest rate environment 

may portend a lower long-term growth rate for corporate earnings and cash flows. When estimating intrinsic value, it is naïve 

to simply reduce the estimated discount rate without also considering the potential adverse consequences for the growth rate 

of cash flows.

Many expect the Federal Reserve to begin increasing shortterm rates later this year. This will have important implications 

for stock prices if longer-term rates begin to increase as well. 

Under one scenario, a slow and gradual increase in long-term 

rates would be bullish, reflecting investors’ positive expectations 

for higher U.S. economic and corporate earnings growth. In 

an alternative scenario, however, interest rates would increase 

dramatically and unexpectedly, which would adversely affect 

stock prices.

In light of this interest rate backdrop, the question is whether 

stock prices have run too far ahead of fundamentals. Although 

certain traditional valuation metrics, such as the market’s forward PE ratio, do not appear alarmingly high relative to historical averages, other metrics to be discussed — the cyclically 

adjusted PE ratio (“CAPE”), the Q-ratio, and the Buffett 

Indicator — are nearing extreme levels, defined as two standard 

deviations (or two-sigma) above historical means.1

Historically, periods of extreme valuations are eventually followed by large market price declines, some of which have 

contributed to systemic crises. On the other hand, extreme valuations have been known to persist for extended periods. For 

example, in a December 1996 speech, former Federal Reserve 

Chairman Alan Greenspan famously used the phrase “irrational 

exuberance” to describe investor enthusiasm for stocks. At that 

time, the forward PE ratio — the ratio of the market price to 

analysts’ consensus earnings forecasts for the next 12 months — 

was approximately 16 times. Although this was above the historical average, it was not alarmingly high. However, the CAPE 

ratio was much higher at 28 times. The S&P 500 more than 

doubled over the next three years, with valuations reaching alltime highs in March 2000, driven by the boom in technology 

stocks. The tech bubble eventually burst; the S&P 500 index 

decreased almost 50 percent and the tech-heavy Nasdaq index 

dropped nearly 80 percent from peak to trough. 

Some Valuation Metrics Are Nearing 

Extreme Highs

Today, equity valuations appear reasonable based on commonly 

used metrics such as the forward PE, price-to-book, and priceto-cash flow ratios.2

 But these metrics do not tell the whole 

story.

Take, for example, the simple PE ratio, which is a quick and 

easy way to evaluate stock prices (see Figure 2). It’s a convention that emerged mostly as a result of “tradition and convenience rather than logic,” according to Robert Shiller.3

 Forward 

PE ratios are potentially misleading for several reasons. First, 

forward one-year earnings are derived from equity analyst projections, which tend to have an upward bias.4

 During boom 

periods, analysts often project high levels of earnings far into 

the future. As a result, forward PE ratios often appear cheap. 

Second, one-year earnings are highly volatile and may not necessarily reflect a company’s sustainable earnings capacity. Third, 

profit margins typically revert toward a longer-term average 

over a business cycle. The risk of mean reversion is particularly 

relevant today, because profit margins are at historic highs and 

analysts forecast this trend to continue. 

Other fundamental valuation metrics tell a different story than 

the forward PE. This brief focuses on a few — the CAPE ratio, 

the Q-ratio, and the Buffett Indicator — that are approaching 

two-standard deviation (two-sigma) thresholds. 

Why is two-sigma relevant? Valuations approached or surpassed two-sigma in each major stock market bubble of the 

past century. And the bursting of asset bubbles has at times had 

important implications for financial stability. The two-sigma 

threshold is useful for identifying these extreme valuation outliers. Assuming a normal distribution in a time series, two-sigma 

events should occur once every 40-plus years; in equity markets, 

they occur more frequently due to fat-tail distributions.5

 

Figure 2. Forward PE Ratio Does Not Imply Valuation 

Risk

0

500

1,000

1,500

2,000

2,500

0

5

10

15

20

25

30

1990 1994 1998 2002 2006 2010 2014

Forward price-to-earnings (PE) rao vs. S&P 500 price

Forward PE rao S&P 500 index

PE average

Sources: Bloomberg L.P.,OFR analysis

Forward PE did not 

signal risk in 2007, 

nor does it today. 
OFR Brief Series March 2015 | Page 3

CAPE Ratio. If one-year earnings assumptions based on peak 

profit margins are potentially misleading, then it seems logical 

to consider valuation metrics based on normalized (long-run 

average) profit margins. In 1934, Graham and Dodd argued 

average earnings should cover a period of at least 5 years, and 

preferably 7 to 10 years, on the basis that current earnings rarely 

reflect a company’s sustainable earnings capacity.6 They noted 

that longer periods are “useful for ironing out the frequent ups 

and downs of the business cycle” and provide a better measure of a company’s earnings power than a single year. Shiller 

enhanced this concept with CAPE (see Figure 3), which is the 

ratio of the S&P 500 index to trailing 10-year average earnings 

(earnings are based on generally accepted accounting principles, or GAAP, and are inflation-adjusted). Although CAPE’s 

10-year timeframe is somewhat arbitrary, it captures earnings 

over one or two business cycles rather than over a single year, 

better reflecting sustainable earnings.

The historical CAPE average based on a 133-year data series is 

approximately 17 times, and its two-standard-deviation upper 

band is 30 times. The highest market peaks (1929, 1999, and 

2007) either surpassed or approached this two-sigma level 

(1999 exceeded four sigma). Each of these peaks was followed 

by a sharp decline in stock prices and adverse consequences 

for the real economy. At the end of 2014, the CAPE ratio (27 

times) was in the 94th percentile of historical observations and 

was approaching its two-sigma threshold. 

Q-Ratio. The Q-ratio, defined here as the market value of nonfinancial corporate equities outstanding divided by net worth, 

suggests a similar message of equity valuations approaching critical levels (see Figure 4).7

 Instead of using a traditional accounting-based (historical cost) measure of net worth, the Q-ratio 

incorporates market value and replacement cost estimates. The 

Q-ratio also includes a much broader universe of nonfinancial 

companies (private and public) than CAPE.

Buffett Indicator. The ratio of corporate market value to gross 

national product (GNP) is at its highest level since 2000 and 

approaching the two-sigma threshold (see Figure 5).8 This 

indicator is informally referred to as the Buffett Indicator, 

because it is reportedly Berkshire Hathaway Chairman Warren 

Buffett’s preferred measure to assess overall market valuation.9

Historically, this indicator’s message is consistent with CAPE, 

particularly in identifying periods of extreme valuation before 

the Great Recession and the 1990s technology stock bubble.

Caveats. The CAPE ratio, Q-ratio, and the Buffett Indicator 

metrics come with caveats: Changes in accounting standards, 

corporate taxation policies, and inflation measurement methodologies complicate the comparability of data over long timeframes. As a result, an average based on a long time period may 

have less relevance today. 

Some also argue that the CAPE ratio, which uses GAAP earnings, sends too bearish a message because it is inflated by record 

low earnings caused by large write-offs during the financial 

CAPE, Q-Ratio, and Buffett Indicator are 

Approaching Two-Sigma Thresholds

Figure 3. CAPE ratio

0

10

20

30

40

50

1881 1897 1914 1931 1947 1964 1981 1997 2014

Average

Two standard deviaons

Dec '99

Sep '29

Dec

'14

Mar '09

Jul '82 Jun '32

May

'07

Note: CAPE is the rao of the monthly S&P 500 price level to trailing 10-year average 

earnings (inflaon adjusted).

Sources: Robert Shiller, OFR analysis

Figure 4. Q-ratio (percent)

Average

Two standard deviaons

0

30

60

90

120

150

180

1951 1958 1965 1972 1979 1986 1993 2000 2007 2014

Note: Q-rao is the market value of nonfinancial corporate equies outstanding

divided by net worth at market value.

Sources: Federal Reserve, OFR analysis

Q1 '00

Q4 '68 

Q3 '14

Q1 '09

Q2 '82 Q3 '53

Figure 5. Ratio of corporate market value to GNP 

(percent)

Average

Two standard deviaons

0

30

60

90

120

150

180

1970 1980 1990 2000 2010

Sources: Haver Analycs, Wilshire Associates, OFR analysis

Note: This is the market value of corporate equies (Wilshire 5000 market

capitalizaon) divided by nominal GNP.

Q1 '00

Q1 '09

Q2 '07 Q3 '14
OFR Brief Series March 2015 | Page 4

-10

-5

0

5

10

15

20

25

0 10 20 30 40 50

Sep

 ' 29 1929

Bubble

Technology Stock 

Bubble

Dec '99 

CAPE rao vs. forward 10-year real returns (1881-2004)

Dec '14 CAPE rao

27x

Sources: Robert Shiller, OFR analysis

Forward 10-year real returns

(percent)

CAPE rao

crisis.10 The primary argument for excluding those charges from 

the analysis is that they are assumed to be nonrecurring and not 

reflective of future earnings potential, which may be true to an 

extent. But generally speaking, write-offs and “special” charges 

(or one-time items) often recur in one form or another. These 

items extract real value from long-term shareholders and are 

relevant when analyzing earnings over multiple business cycles. 

Another counterargument to CAPE’s critics is that earnings for 

many companies were overstated leading up to the last crisis; so 

later write-offs simply corrected for the overstatement. Finally, 

despite the inclusion of write-offs in GAAP earnings, it is interesting to note that CAPE’s trailing 10-year average earnings are 

well above, not below, the historical trend (see Figure 6). 

Other caveats are worth noting for the Q-ratio and the Buffett 

Indicator. The Q-ratio excludes financial corporations, such 

as banks and financial services companies (these entities contributed to excessive valuations in the mid-2000s). The Buffett 

Indicator has an upward bias because foreign profits of U.S. 

corporations have increased over time.

However, these caveats do not invalidate the usefulness of these 

metrics, which each cover long timeframes. Although no two 

market cycles are exactly the same, history provides important lessons in interpreting trends and outliers. The trade-off of 

excluding large portions of history because of imperfect data is 

loss of perspective. In particular, during financial booms, analysts extrapolate record profit margins far into the future, ignoring history and the forces of mean reversion. 

Evaluating the Possibility of a Market 

Correction

History shows a clear relationship between the CAPE ratio 

and forward 10-year compounded annual real returns (see 

Figure 7).11 High valuations today imply lower future returns. 

However, none of these valuation metrics — the CAPE ratio, 

the Q-ratio, or the Buffett Indicator — predicts the timing of 

inflection points, and markets may remain undervalued or overvalued for very long periods. But we can use these metrics as 

barometers to gauge when valuations are reaching excessively 

high or low levels. 

The timing of market shocks is difficult, if not impossible, to 

identify in advance, let alone quantify — a shock, by definition, 

is unexpected. When assessing asset valuation it is important to 

make a distinction between risk and uncertainty. Risk may be 

quantified and described in probabilistic terms, and analysts can 

factor this into their valuation models. However, uncertainty is 

hard to quantify because it refers to future events that cannot 

be fully understood or quantified. Today’s high stock valuations 

imply that investors underestimate the potential for uncertain 

events to occur. 

Figure 8 shows the relationship between valuation and future 

returns more explicitly. Historically, the highest returns follow 

periods of low valuations (CAPE < 10) and the lowest returns 

Figure 6. Earnings Mean Revert Over Time and Are 

Well Above Trend

Figure 7. CAPE Is High Relative to Historical Levels 

1

10

100

1881 1897 1914 1931 1947 1964 1981 1997 2014

S&P 500 real earnings vs. trend ($ per share, logarithmic scale)

Twelve month

Rolling 10-year

Sources: Robert Shiller, OFR analysis

Trendline (Rolling 10-year)

Great 

Recession

Great 

Depression
OFR Brief Series March 2015 | Page 5

follow periods of high valuations (CAPE > 30). When setting 

expectations for future returns, CAPE appears most relevant at 

these extreme lows (expect above-average future returns) and 

highs (expect below-average future returns). In fact, real returns 

were negative, as shown in Figure 8, when CAPE exceeded the 

two-sigma threshold. Similar conclusions may be drawn from 

other metrics, such as the Q-ratio and Buffett Indicator, but the 

historical time series associated with them are shorter. 

To be clear, extreme valuations (2-sigma) are only one characteristic of a potential bubble. Valuation in isolation is not necessarily sufficient to trigger a downturn, let alone pose risks to 

financial stability. Other factors are relevant for analyzing market cycles — most important, corporate earnings.

Robust growth in corporate earnings is the primary driver 

behind the stock market’s gains over the past several years. But 

sales growth has been much more modest. Since the cyclical 

low in 2009, earnings have increased at a double-digit annual 

growth rate while sales have increased at a more modest midsingle-digit rate. The higher trend growth in earnings versus 

sales is due to rising profit margins. S&P 500 profit margins 

reached a record 9.2 percent (trailing 4-quarter, GAAP) in the 

third quarter of 2014 (see Figure 9), well above the historical 

average of 6.3 percent. 

Broader measures of corporate profitability (before and after 

tax) tell a similar story (see Figure 10). The Bureau of Economic 

Analysis corporate profit data series covers approximately 9,000 

companies, public and private, so it is a much broader measure 

than S&P 500 profits. 

To date, record high margins are in part supported by favorable 

secular trends: a greater proportion of high margin sectors in 

the S&P 500 composite, lower corporate effective tax rates due 

to a higher mix of foreign profits, and productivity improvements such as automation and supply chain enhancements. The 

lower margin, capital-intensive sectors that dominated the market index in earlier decades have given way to more profitable 

and less capital-intensive sectors due to the computing revolution (early 1980s) and the gradual transition to a services-driven 

economy. Since the 1970s, lower margin, capital-intensive sectors (industrials, materials, and energy) have fallen from 39 to 

22 percent of S&P 500 market capitalization, while higher margin sectors (technology, financials, and health care) have risen 

from 23 to 50 percent. 

Other favorable cyclical factors have also helped to boost profitability, including low interest rates, low labor costs, cost-cutting initiatives, and positive operating leverage (high fixed costs 

relative to variable costs). However, many of these are not sustainable. Current historically low interest rates will eventually 

rise. Labor costs will increase as unemployment decreases, and 

cost-cutting initiatives, such as underinvestment in research 

and development and capital spending (key sources of future 

revenue growth), cannot continue indefinitely. Finally, positive 

operating leverage works in reverse when the sales cycle turns. 

Figure 8. High CAPE Implies Low Future Returns12

CAPE

Annualized Total Returns Per Year Over 

Subsequent 10-Year Period

Nominal (percent) Real (percent)

Median High Low Median High Low

5-10x 15.2 21.1 -0.2 11.0 20.0 1.8 

10-15x 11.7 19.8 2.7 7.7 17.6 -4.1 

15-20x 8.0 19.3 -0.4 6.1 16.1 -4.6 

20-25x 6.0 11.7 -2.6 3.9 9.0 -4.0 

25-30x 7.5 9.2 -3.4 4.9 6.5 -1.2 

> 30x 1.2 7.3 -4.0 -1.1 4.5 -5.9 

Source: OFR analysis

Figure 9. Profit Margins Are at Record Highs

0

3

6

9

12

1993 1996 1999 2002 2005 2008 2011 2014

S&P 500 profit margin (percent, trailing 4-quarter)

Sources: S&P Dow Jones Indices, OFR analysis

Non-GAAP

GAAP

GAAP

average

Q3 2014

Q2 2007
OFR Brief Series March 2015 | Page 6

Of course, the current cycle could continue as long as revenue 

growth offsets these margin pressures. 

Taking a longer-term view, beyond a single cycle, competitive 

market forces are another key factor that limits future margin 

expansion. Profitable industries eventually attract new capital 

and new competitors, ultimately reducing margins over time in 

mature industries. This is particularly true in a highly competitive global economy.

Mean reversion in margins has important implications for 

equity valuations. The current forward PE ratio appears reasonable only if record margins are sustained. During business 

cycle peaks, when margins are high, investors often fail to factor 

margin mean reversion into earnings estimates and then adjust 

forward PEs lower to compensate for this risk. 

Financial Stability Implications 

Extreme asset valuations can have implications for financial stability. Although the bursting of the technology stock bubble 

in the early 2000s did not disrupt the functioning of financial 

markets, the other two major crashes of the past century, following the 1929 and 2007 peaks, contributed to widespread 

financial instability. 

Broadly speaking, systemic crises tend to be preceded by bubbles in one asset class or another. Brunnermeier and Schnabel 

identified four factors that accelerate the emergence of asset 

bubbles: expansive monetary policy, lending booms, foreign 

capital inflows, and financial deregulation.13 They concluded 

that the financing of bubbles is much more relevant than the 

type of asset bubble, noting that “bubbles in stocks may be just 

as dangerous as bubbles in real estate if financing runs through 

the financial system.” They also noted that the spillover effects 

of bubbles bursting are most severe when accompanied by a 

lending boom, high leverage, and liquidity mismatch of market 

players.

Adrian, Covitz, and Liang defined systemic risk as the potential 

for widespread financial externalities, whether from corrections 

in asset valuations, asset fire sales, or other forms of contagion, 

to amplify financial shocks and, in extreme cases, disrupt financial intermediation.14 They noted that systemic risks may arise 

from vulnerabilities such as leverage, maturity and liquidity 

transformation, compressed pricing of risk, interconnectedness, 

and complexity. For these reasons, it is important for regulators to consider potential systemic risk implications when asset 

prices approach extremes.

The U.S. stock market may pose fewer financial stability risks 

because liquidity transformation is less relevant compared to 

other financial markets, such as certain fixed-income markets. 

However, other vulnerabilities that may amplify shocks could 

be more relevant to assessing financial stability risks. These 

include leverage, compressed pricing of risk, interconnectedness, and complexity.

Average

Two standard deviaons

-4

0

4

8

12

1929 1941 1953 1965 1977 1989 2001 2013

Corporate profits aer tax divided by nominal GNP (percent) 

Sources: Bureau of Economic Analysis, OFR analysis

1929

2006 2013

Figure 10. Broader Measures of Profits Are High 

4

6

8

10

12

14

1948 1959 1970 1981 1992 2003 2014

Corporate profits before tax divided by nominal GNP (percent) 

Average

Sources: Bureau of Economic Analysis, OFR analysis

Q4 1950

Q3 2014 Two standard deviaons
OFR Brief Series March 2015 | Page 7

Leverage. Leverage can magnify the impact of asset price 

movements. Leverage achieved through stock margin borrowing played an important role in inflating stock prices in the 

1929 stock market bubble and to a lesser extent in the late 

1990s technology stock bubble. Margin debt, according to the 

Financial Industry Regulatory Authority, reached a record $500 

billion at the end of the third quarter of 2014, representing just 

over 2 percent of overall market capitalization. Although this 

percentage is below the peak in 2008, it is higher than historical 

levels (see Figure 11). The percentage does not appear alarmingly high, but forced sales of equities by large leveraged investors at the margin could be a catalyst that sparks a larger selloff. 

Other forms of leverage, such as securities lending and synthetic 

leverage achieved through derivatives, may also present risks.

Another component of leverage in the system is the financing 

activities of corporations. Today, high profits have made corporate balance sheets generally quite healthy. As of the third quarter of 2014, U.S. nonfinancial corporations held a near-record 

$1.8 trillion in liquid assets (cash and financial assets readily 

convertible to cash). However, corporations also have racked up 

a record amount of debt since the last crisis. 

U.S. nonfinancial corporate debt outstanding has risen to $7.4 

trillion, up from $5.7 trillion in 2006. Proceeds from debt 

offerings have largely been used for stock buybacks, dividend 

increases, and mergers and acquisitions. Although this financial 

engineering has contributed to higher stock prices in the short 

run, it detracts from opportunities to invest capital to support 

longer-term organic growth. Credit conditions remain favorable today because of the positive trend in earnings, but once 

the cycle turns from expansion to downturn, the buildup of 

past excesses will eventually lead to future defaults and losses.15

If interest rates suddenly increase, then financial engineering 

activities will subside, removing a key catalyst of higher stock 

prices. 

Compressed Pricing of Risk. Asset prices based on compressed risk pricing are prone to drop, and severe drops may 

pose a risk to financial stability. Today’s high valuation multiples imply that investors are willing to accept a much lower risk 

premium (and weaker than average stock returns) in the future. 

The equity risk premium (ERP), which reflects the additional 

return an investor expects to receive over risk-free assets, such as 

U.S. Treasuries, is an important component of asset valuation 

models (it is a key part of the discount rate used to calculate 

the present value of future cash flows). The market’s historical 

ERP has averaged 4.5 percent since 1900, but this premium 

itself is a random variable that changes over time as investor 

expectations change.16 As a result, the historical ERP offers only 

limited insight into the future (implied) ERP.17 As stock prices 

appreciate materially during the latter stages of a bull market 

phase, risk pricing is compressed and implied ERPs decrease, 

leaving investors with little margin of safety. 

Interconnectedness. The U.S. equity market is highly interconnected with other financial markets, such as equity options 

Figure 11. Margin Debt Is at a Record High

0.0

0.5

1.0

1.5

2.0

2.5

3.0

0

150

300

450

600

1972 1979 1986 1993 2000 2007 2014

Margin debt ($ billions and percent)

Margin debt ($ billions) Percent of market cap

Sources: FINRA, Wilshire Associates, OFR analysis

Note: Market capitalizaon refers to the Wilshire 5000 index.
OFR Brief Series March 2015 | Page 8

and futures markets and global equity markets, making it possible for weakening financial conditions to propagate rapidly 

from one financial market to another. The larger the market, 

the more pronounced the feedback loops. And the U.S. equity 

market (excluding options and futures) is large at more than 

$24 trillion in market capitalization. 

The equity market is also interconnected with the real economy. 

Equity markets play an important role in capital formation for 

corporations that seek to access funds through stock offerings. 

In addition, U.S. households and stock markets are interlinked 

— 49 percent of families directly or indirectly own stocks.18

Given these interconnections, when asset bubbles burst they 

can adversely impact corporate and consumer spending; these 

negative consequences are typically long-lasting. Reinhart and 

Rogoff analyzed systemic financial crises in several developed 

and developing economies and found that crises sparked by 

asset market collapses (generally following extreme asset price 

levels) were deep and prolonged.19

Complexity. The underlying plumbing, or market microstructure, of the equity market is highly complex, and that complexity 

may pose a risk to core market functions, such as price discovery 

and liquidity provisioning.20 The equity market plumbing usually functions efficiently and effectively. However, complexity 

could pose a risk to financial stability if an impairment of core 

functions occurs during a period of broader market stress, such 

as when an asset bubble bursts. Examples of complexity include 

automated algorithm-based high-frequency trading and order 

routing systems. These technologies greatly reduce transactions 

costs and trade execution speeds, but regulators and market participants have little transparency into how these systems work. 

The Flash Crash in May 2010 illustrates how market price 

movements are amplified by aggressive automated-based trading, which can trigger a chain reaction of selling. Complexity 

is also evident in the decentralized (fragmented) nature of stock 

trading as equities may trade across a large number of venues, 

both on- and off-exchange. Market prices may be more sensitive 

to liquidity shocks in these fragmented markets, resulting in 

more extreme price changes during periods of stress.

Although overall equity valuations appear high today, the relevance of the financial stability risks noted above may come 

down to financial sector valuations. Today, valuations for financial stocks appear more reasonable. Financial stability risks are 

more prominent when valuations are excessively high for both 

the overall market and the financial sector, due to the important 

role the latter plays in credit intermediation. Before the last crisis, financial stocks were significantly overvalued and comprised 

a record 22 percent of the S&P 500’s market capitalization in 

2006. The subsequent stock market decline contributed to the 

financial crisis. In contrast, the bursting of the market bubble in 

2000, following the technology stock boom of the 1990s, did 

not pose any financial stability risks; back then, financial stocks 

represented only 14 percent of the overall market capitalization. 

As of the end of 2014, this percentage has increased to almost 

17 percent, which is moderately above the sector’s historical 

average (15 percent) but not alarmingly high. 

Conclusion

Markets can change rapidly and unpredictably. When these 

changes occur they are sharpest and most damaging when asset 

valuations are at extreme highs. High valuations have important 

implications for expected investment returns and, potentially, 

for financial stability.

Today’s market environment is different in many ways from the 

period preceding the Great Recession, because regulators and 

market participants have made adjustments to enhance financial stability since the financial crisis. In that time, stock returns 

have been exceptional and market volatility generally subdued. 

Today, many market strategists see the bull market extending 

throughout 2015.

However, quicksilver markets can turn from tranquil to turbulent in short order. It is worth noting that in 2006 volatility was 

low and companies were generating record profit margins, until 

the business cycle came to an abrupt halt due to events that 

many people had not anticipated. Although investor appetite 

for equities may remain robust in the near term, because of positive equity fundamentals and low yields in other asset classes, 

history shows high valuations carry inherent risk. 

Based on the preliminary analysis presented here, the financial 

stability implications of a market correction could be moderate 

due to limited liquidity transformation in the equity market. 

However, potential financial stability risks arising from leverage, 

compressed pricing of risk, interconnectedness, and complexity 

deserve further attention and analysis.
OFR Brief Series March 2015 | Page 9

Endnotes

1 See Jeremy Grantham, “Looking for Bubbles,” 

GMO Quarterly Letter, GMO LLC, First Quarter 

2014; and “Pavlov’s Bulls,” GMO Quarterly 

Letter, GMO LLC, Fourth Quarter 2010.

2 There are a number of ways to assess equity 

market valuation. This brief is not intended to 

represent a comprehensive review of all methods.

3 See Robert J. Shiller, “Price-Earnings Ratios 

as Forecasters of Returns: The Stock Market 

Outlook in 1996,” online paper, July 21, 1996 

(available at www.econ.yale.edu/~shiller/data/peratio.html, accessed January 29, 2015).

4 Several studies document analyst optimism in 

earnings forecasts: see Greg Harrison, “Estimates 

Too High, Low? Check The Calendar,” Thomson 

Reuters, February 11, 2013; Robert H. Ashton 

and Anna M. Cianci, “Motivational and 

Cognitive Determinants of Buy-Side and SellSide Analyst Earnings Forecasts,” The Journal 

of Behavioral Finance 8, no. 1 (2007), 9-19; 

Stan Beckers, Michael Steliaros, and Alexander 

Thomson, “Bias in European Analysts’ Earnings 

Forecasts,” Financial Analysts Journal 60, no. 

2 (2004), 74-85; Werner F.M. DeBondt and 

Richard H. Thaler, “Do Security Analysts 

Overreact?,” American Economic Review 80, no. 

2 (1990), 52-57; Lawrence D. Brown, “Analyst 

Forecasting Errors: Additional Evidence,” 

Financial Analysts Journal 53, no. 6 (1997), 

81-88; and Rafael LaPorta, “Expectations and the 

Cross-Section of Stock Returns,” The Journal of 

Finance 51, no. 5 (1996), 1715-1742.

5 See Grantham (2014).

6 See Benjamin Graham and David L. Dodd, 

Security Analysis (New York: McGraw Hill), 

1934.

7 Net worth at market value (denominator of 

Q-ratio) is derived by subtracting liabilities from 

assets stated at either market value or replacement 

cost, as shown in Table B.102 of the Federal 

Reserve’s Financial Accounts of the United States 

(see www.federalreserve.gov/releases/z1/, accessed 

February 26, 2015). For more on the Q-ratio, see 

Andrew Smithers, Wall Street Revalued (United 

Kingdom: John Wiley & Sons Ltd.), 2009. 

8 The historical time series for the ratio of corporate 

market value-to-GNP is similar to that of the 

S&P 500 price-to-sales ratio.

9 See Carol Loomis, “Warren Buffett on the Stock 

Market,” Fortune, December 10, 2001.

10 This same criticism of the CAPE ratio was made 

in the mid-2000s when it was at a similar level 

as today. At that time, the ratio included low 

earnings during the 2001 recession.

11 Figure 7 shows CAPE ratios from January 1881 

through December 2004 and the subsequent 

10-year annual return for each CAPE ratio. Ratios 

after this period are not shown because 10-year 

returns are not yet determined.

12In Figure 8, median refers to the historical return 

in the 50th percentile of observations. Half of 

historical returns are greater than and half are less 

than the median. 

13 See Markus Brunnermeier and Isabel Schnabel, 

“Bubbles and Central Banks: Historical 

Perspectives,” online paper, July 18, 2014 (available at scholar.princeton.edu/sites/default/files/

markus/files/20140718_bubblescentral_banks_0.

pdf, accessed January 29, 2015).

14 See Tobias Adrian, Daniel Covitz, and Nellie 

Liang, “Financial Stability Monitoring,” Federal 

Reserve Bank of New York Staff Report no. 

601, June 2014 (available at www.newyorkfed.

org/research/staff_reports/sr601.pdf, accessed 

February 26, 2015).

15 See Office of Financial Research (OFR), 2014 

Annual Report, Washington, 20.

16 See Elroy Dimson, Paul Marsh, Mike Staunton, 

and Michael Mauboussin, “Credit Suisse Global 

Investment Returns Yearbook 2014,” online 

report, February 2014 (available at publications.

credit-suisse.com/tasks/render/file/?fileID=0E0A3

525-EA60-2750-71CE20B5D14A7818, accessed 

January 29, 2015).

17 See Clifford Asness, “Fight the Fed Model,” The 

Journal of Portfolio Management 30, no. 1 (Fall 

2003), 11-24; and Aswath Damodaran, “Equity 

Risk Premiums (ERP): Determinants, Estimation 

and Implications,” online paper, March 23, 2013 

(available at papers.ssrn.com/sol3/papers.cfm?abstract_id=2238064, accessed January 29, 2015). 

18 See Jesse Bricker, Lisa J. Dettling, Alice 

Henriques, Joanne W. Hsu, Kevin B. Moore, 

John Sabelhaus, Jeffrey Thompson, and Richard 

A. Windle, “Changes in U.S. Family Finances 

from 2010 to 2013: Evidence from the Survey 

of Consumer Finances,” Federal Reserve Bulletin

100, no. 4 (September 2014).

19 See Carmen Reinhart and Kenneth Rogoff, “The 

Aftermath of Financial Crises,” NBER Working 

Paper 14656, Cambridge, Mass., January 2009 

(available at www.nber.org/papers/w14656, 

accessed February 27, 2015). The authors noted 

that severe asset market collapses are associated 

with an average peak-to-trough decline of 35 percent in real housing prices over a six-year period, 

an average decline of 55 percent in equity prices 

over three-and-a-half years, an average increase 

of 7 percentage points in the unemployment rate 

over four years, and an average increase of 86 

percent in government debt since World War II.

20 See OFR (2014), 38-40.