(Bloomberg View) -- U.S. stocks have enjoyed a nearly uninterrupted bull market since late 2009. Two factors have helped create a Goldilocks scenario that helped drive this surge. First, the shock administered by the 2008-2009 financial crisis left stocks significantly undervalued, creating plenty of room for equity prices to recover. Second, U.S. inflation has consistently held below the Federal Reserve's 2 percent target, leaving the central bank with little reason to tighten monetary policy.
Conditions are now changing. Our favorite indicator for U.S. equity valuations now shows that the S&P 500 index has become slightly overvalued. This overvaluation is not dramatic, but it is the largest since 2008.
At the same time, inflation looks set to overshoot the Fed's target in the medium term. The overshoot won't be large, but it could ultimately trigger faster rate hikes than presently are being priced by the market. That could cause the bond market's yield curve to invert, as short-term rates rise above those for longer-term maturities. A yield curve inversion is normally a clear signal the economy is heading for a recession. We're not there yet, but the risks are rising.
It seems like a good time to take a more cautious approach to U.S. and global stocks, as well as riskier assets in general. That does not mean a major market sell-off is imminent, as the momentum in U.S. stocks is still positive. But if investors want to assess the timing of a possible pullback, it makes sense to take a closer look at these momentum indicators.
Stock market bears have long warned of a looming setback, pointing to the all-time highs in equity valuations as measured by price-to-earnings ratios, for example. We have been skeptical about this argument, because today's high P/E ratios largely reflect a structural decline in interest rates.
The graph below shows the S&P 500 trading slightly above our valuation indicator, which is a variation of the so-called Fed model, based on nominal gross domestic product (as a proxy of earnings) and corporate bond yields. The last time that happened was late 2015, just before the stock sell-off of early 2016. However, the overvaluation relative to the nominal S&P 500 index is higher now, reaching a level not seen since early 2008.
By itself, the elevated valuation is a reason to worry about a possible market setback, and it certainly is an indication of growing downside risks to the market. But an even greater cause for concern is that the Fed and European Central Bank may both step up their hawkish rhetoric. That would also be bad news for riskier assets.
Our indicator for U.S. monetary conditions, which is based on money supply and nominal GDP growth as well as exchange-rate and interest-rate movements, suggests that inflation is picking up. As the graph below shows, our monetary indicator has recently risen above zero, meaning there is a greater probability inflation the will rise above the Fed's target than stay below. The increase in the indicator was mainly driven by the recent acceleration in the U.S. dollar's decline.
In such conditions, it seems prudent that policy makers would raise rates at least in line with the present market pricing and perhaps even more aggressively. Given higher inflation risks, it would also be natural to expect the Fed to modulate its rhetoric in a more hawkish direction -- and that is exactly what our indicator for the Fed's forward guidance is showing.
The Forward Guidance Indicator is a quantitative measure based on language used by the Fed in policy statements. We have estimated a model for changes in the FGI based on business cycle indicators as well as inflation expectations. As the graph below shows, the predicted forward guidance is more hawkish than the Fed's actual rhetoric. That could indicate that policy makers will soon take a hawkish turn.
We see a similar picture with the ECB, with the FGI trending higher over the past two years. Continued strong economic data could cause the ECB to become more hawkish in its rhetoric.
A combination of overvalued equities and tighter monetary condition is normally bad for stock markets and riskier assets in general. Just how big the coming sell-off will be is hard to say. To a large extent, it will depend on how monetary policy responds. It seems prudent to take some risk off the table.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Lars Christensen is the founder and CEO of Markets & Money Advisory. He was formerly the head of emerging markets research at Danske Bank.
To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net.
For more columns from Bloomberg View, visit http://www.bloomberg.com/view.
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