Data Agency Warns of Next Potential Systemic Shock

WASHINGTON — The U.S. financial system may be on the verge of another systemic crash, according to a provocative new report issued this week by the Office of Financial Research.

The report posited that certain stock market conditions resemble the climate just before crises hit in 1929, 2000 and 2007. While some metrics like price-to-earnings ratio are within normal bounds, other indicators suggest that markets are overvalued and headed for a correction for which the financial system may not be adequately prepared.

"The timing of market shocks is difficult, if not impossible, to identify in advance, let alone quantify — a shock, by definition, is unexpected," wrote Ted Berg, a researcher for the data research agency, which among other things provides analysis and information to the Financial Stability Oversight Council. "Today's high stock valuations imply that investors underestimate the potential for uncertain events to occur."

In the paper, Berg said that some measures show a strong correlation to the market climate today and the market conditions just before major market corrections. The ratios he cites are the cyclically-adjusted price-to-Earnings, or CAPE, ratio, which considers earnings compared to a 10-year S&P 500 index average; the Q-ratio, which compares the value of nonfinancial equity value with net worth; and the Buffett Indicator, which compares corporate market value to gross national product.

An analysis of CAPE ratios from 1881 to the present demonstrates a handful of market periods where the ratio approached or exceeded two standard deviations above the long-term average, and those periods — including September 1929, December 1999, May 2007 and December 2014. Berg noted that "each of these peaks was followed by a sharp decline in stock prices and adverse consequences for the real economy."

A chart of the Q-ratio from 1951 to the present likewise shows peaks and valleys that correspond to moments of market upheaval, as does a mapping of the Buffett Indicator from 1971 to the present. All of those indicators show the present market conditions as reminiscent of markets just before a major market correction, Berg said, and the potential for such a stock crash to affect the broader financial system is formidable.

One area Berg zeroed in on is leveraged loans, which regulators have been raising concerns about. The use of leveraged loans to purchase equity makes up roughly 2% of overall market capitalization, Berg said, accounting for roughly $500 billion in the market (a characteristic shared with the crashes in 2000 and 2007).

Investors' expectations for greater financial gains in the market as opposed to less-risky markets like Treasury bonds, which often occurs toward the tail end of a bull market, tends to inflate market valuations and limit margins for safety, Berg said. The equities markets are also highly interconnected with other financial markets and the real economy, increasing the risk of market contagion. The complexity of the equities markets also make it challenging to accurately assess market price and liquidity.

Berg did present several caveats to the data. Accounting changes, tax changes and measures of inflation have changed substantially over time, making data hard to compare perfectly over such a long time horizon. Changes to capital rules and other adjustments have also made market participants more able to withstand financial upheavals than they were before the financial crisis, Berg said. But certain factors have the potential of making a stock crash reverberate throughout the financial system.

"Broadly speaking, systemic crises tend to be preceded by bubbles in one asset class or another," Berg said. "Potential financial stability risks arising from leverage, compressed pricing of risk, interconnectedness and complexity deserve further attention and analysis."

The paper comes as FSOC is poised to receive public comment March 25 on its proposal to regulate the asset management industry — a major player in equities markets — as systemically important. The move would be the council's first foray into an "activities-based" systemic resolution that some observers say could address so-called shadow banking activities by nonbanks.

The findings appear to support the view that leverage in the financial markets and excessive reliance on Tier 1 Capital buffers could presage a broader crisis. Simon Johnson, a professor at the Massachusetts Institute of Technology School of Management, said during a conference at George Washington University on Friday that the capital rules should be adjusted to favor a greater share of equity in capital buffers to withstand a market shock.

"Capital has increased since the crisis, from a low level to a slightly above low level," Johnson said. "If these [buffers] were much more financed with equity rather than debt … they would become more careful and more responsible and less inclined to repeat what they did in the run-up to" the financial crisis."