Stock and Bond Valuations are a Warning to Investors

The last decade and a half rewarded investors with healthy stock and bond returns. But high valuations, low interest rates and high inflation are signals to reassess risk tolerance and asset allocations.

In his new, excellent book, Investing Amid Low Expected Returns, Antti Ilmanen showed that equities have performed best in “growth up and inflation down” periods and worst in opposite periods, while government bonds have performed best in “growth down and inflation up” periods. In my role as chief research officer at Buckingham Wealth Partners, I have noted a significant increase in investor concerns caused by: the much greater increase in inflation than either the Fed or the financial markets anticipated; the additional inflationary pressures created by the invasion of Ukraine; the large reduction in fiscal stimulus that was provided to mitigate the effects of the COVID crisis; and the Federal Reserve finally moving to tighten monetary policy (both by raising interest rates and reducing its balance sheet). The result is that investors are concerned about heightened risks to the economy, and to both equity and bond valuations – with many now worried about the dual risks of recession and inflation (stagflation).

With these concerns in mind, it is helpful to review what the financial literature has to say about the ability to predict crises. Then we will look at how the current situation relates to the indicators that provide predictive information.

Research findings

Research, such as the 2021 study, “Predictable Financial Crises,” the 1997 study, “Leading Indicators of Currency Crises” and the 2009 study, “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles, and Financial Crises, 1870-2008,” has found that rapid credit creation, money supply growth, asset price bubbles (especially in housing – booms in housing prices are one of the leading indicators of financial crises), investment booms, savings shortfalls, large capital inflows, low credit spreads, yield curve inversion and overvalued exchange rates inform the predictability of financial crises. The research also finds that late-stage indicators, such as rising real interest rates, incipient inflation, falling bank deposits, international reserve depletion and trade shocks, are useful predictors of crises. In addition, composite models, combining the individual leading indicators, produce superior crises forecasts. And finally, composite models could have predicted many major historical crises, including the global financial crisis (GFC) that began in 2007.