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Investment Ideas Why this bearish market outlook is especially unnerving

Bears, take heart. If you've been embarrassed because your friends think you're too gloomy about the stock market, you can now point them to your new buddy in pessimism – the U.S. government.

The Office of Financial Research, which was set up as part of Washington's postcrisis wave of reform "to shine a light in the dark corners of the financial system," issued a report earlier this month that concludes the outlook for stocks is very dim indeed.

Three yardsticks of stock market valuation – the cyclically adjusted price-to-earnings (CAPE) ratio, the Q ratio and the Buffett indicator – are all nearing extreme levels, which the OFR report defines as two standard deviations above historical averages. (Standard deviation is a measure of the distance between a data point and its average value).

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"Historically, periods of extreme valuations are eventually followed by large market price declines, some of which have contributed to systemic crises," writes Ted Berg, author of the report.

To be sure, extreme valuations can persist for a long time, Mr. Berg cautions. But history shows that lofty prices eventually collapse back to more normal levels.

That message isn't exactly new, of course. Others have also pointed to the stretched valuations in today's stock market. But the OFR report is noteworthy because it's a rare example of a government agency pronouncing judgment on asset prices.

Bureaucrats and policy makers have traditionally shied away from expressing opinions on such topics. For decades, the belief was that markets were highly efficient at pricing goods and should largely be left to their own devices.

In the wake of the financial crisis, that hands-off attitude is shifting. Bank of Canada Governor Stephen Poloz, for instance, warned in December that the central bank's new forecasting model indicates home prices are 10 per cent to 30 per cent too high.

In looking at stock prices, the OFR report approached the question of valuation from three perspectives.

The first, the CAPE ratio, compares the current prices of stocks to their average annual earnings over the past decade. The second, the Q ratio, measures the value of the stock market against the replacement value of its assets.

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The third approach, shown in the accompanying graph, sets the market value of corporate equities against the output, or gross national product, of the United States. It's often referred to as the Buffett indicator because many people believe it is Warren Buffett's preferred measure of the overall market.

The three approaches deliver similar messages. All show that U.S. stocks are now far pricier than usual and at levels only seen on rare occasions in the past. The degree of overvaluation is less than during the dot-com bubble but similar to 2007.

Bulls can still point to some indicators, such as the ratio of stock prices to estimated earnings over the next year, which are more optimistic about what lies ahead.

However, the weight of the evidence is squarely on the side of the bears, especially given the advanced age of the current bull market.

"Although the positive trend could continue, the upturn [in the stock market] has persisted much longer and prices have risen much higher than most historical bull markets, despite a weaker-than-normal macroeconomic recovery," Mr. Berg writes.

Does this mean you should dump stocks? Much depends on your attitude to risk. High valuations are usually not enough by themselves to trigger a selloff.

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However, a slowdown in corporate profits could do the job. Profit margins at U.S. companies reached a record high of 9.2 per cent in the third quarter of 2014, far above the historical average of 6.3 per cent. If those margins start to fall, stock prices are likely to follow – and quite quickly.

"Quicksilver markets" such as today's can turn from tranquil to turbulent in a hurry, Mr. Berg warns. The good news, he says, is that regulators have taken measures since 2008 to enhance financial stability, so even a plunging market might wind up having only a moderate effect on the real economy.

For shareholders, though, the takeaway from Mr. Berg's report seems clear. "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."

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