In the semi-annual Financial Stability Report, the Fed issued a stock market warning as elevated valuations are causing markets to be “vulnerable to significant declines”. To wit:
Prices of risky assets generally increased since the previous report, and, in some markets, prices are high compared with expected cash flows. House prices have increased rapidly since May, continuing to outstrip increases in rent. Nevertheless, despite rising housing valuations, little evidence exists of deteriorating credit standards or highly leveraged investment activity in the housing market. Asset prices remain vulnerable to significant declines should investor risk sentiment deteriorate, progress on containing the virus disappoint, or the economic recovery stall.
Is the Fed’s stock market warning justified?
The Fed is stating that valuations, as the prices of “risky” assets keep rising, make the stock market continually more vulnerable to a crash. It is the “stability/instability” paradox.
What could cause asset prices to crash? The Fed notes specifically:
- Another surge, or variant, of the COVID virus,
- A stalling of the economic recovery, or;
- Investor “risk-sentiment” deteriorates
Given that Fed interventions boosted the stock market and “investor sentiment,” the withdrawal of that support could be problematic. As I discussed in “Bob Farrell’s Rules For A QE Market:”
“The high correlation between the financial markets and the Federal Reserve interventions is all you need to know to navigate the market.“
Those direct or psychological interventions are the basis for justifying all the speculative “risk” investors can muster.