London-based strategist Andrew Smithers argues that "everything" is overvalued–stocks, houses, REITs, and even art. In his view, there are only two ways the situation can correct itself: 1) asset prices will fall, or 2) inflation will rise. Displaying unusual confidence in the inflation-fighting resolve of central bankers, Smithers argues that solution 1 is more likely. This adjustment process, he believes, will lead to a major recession.
There is a high risk that the next recession will be severe, either by being prolonged or by being unusually deep. The fundamental problem is that asset prices have risen to such high levels relative to incomes. This applies to shares, houses, other forms of real estate, gold and even art.
With assets so far out of line with incomes, either asset prices will have to fall in nominal terms or incomes will have to rise at an inflationary pace. It will be extremely difficult to manage the economy during the adjustment process, whether the route is rising inflation or falling asset prices.
Here, Smithers bases his valuation assessment on the relationship between prices and incomes. In other forums–namely research reports from Smithers & Co.–he makes the same argument using the cyclically adjusted P/E ratio. Neither measure is of any use for short-term market timing, as Smithers will surely be the first to attest. The cyclically-adjusted P/E, however, has in the past had significant predictive capability.
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