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Financial markets are ‘entering frothy territory’ Deutsche Bank says

Stocks are entering “frothy territory” and could fall soon due to a turnaround in monetary policy, a Deutsche Bank economist said Monday, citing analysis that is used by some of the more notable names in finance.

“We believe the equity market in developed countries begins to show symptoms of ‘froth,'” Mikihiro Matsuoka, chief economist at Deutsche Bank, said in a note.

“The reason we believe it is entering frothy territory is that an eventual turnaround of monetary policy after a long period of post-[great financial crisis] accommodation is under way in major developed countries, which in our view, raises the returns on safe assets and lowers the valuation of risk assets,” he said.

Matsuoka pointed to a chart comparing the stock market capitalization of seven major developed countries to their gross domestic products. The line below represents the average standard deviation — distance from a historical norm — of how much the stock markets are worth as a percentage of GDP.

Stock market capitalization (% of GDP) in G-7 countries

Source: Haver Analytics, Deutsche Bank Global Markets Research

Note: A simple average of standard deviation obtained from each country in 1991 – 2016 data. G-7 includes Australia, Canada, Germany, Japan, Switzerland, UK and US.

This year’s high of 1.30 in May is approaching recent peaks of 1.34 in May 2015, 1.61 in May 2007, just before the financial crisis, and 1.45 in August 2000, during the collapse of the tech bubble. The preliminary read for June was 1.29, the report said.

The chart is similar to one Warren Buffett said he watches as a key measure of valuation, and in April reclusive hedge fund legend Paul Tudor Jones reportedly said a chart similar to this one should be “terrifying” to central bankers.

A July version of the chart calculated by dshort.com shows investors value U.S. stocks at 127.6 percent of GDP, the highest since around the tech bubble in 2000 when the reading was 136.5 percent.

U.S. stocks have surged to record highs since the election, despite a host of worries, including concerns about sluggish global growth and geopolitical tensions. Analysts have also criticized easy monetary policy for artificially supporting high stock prices.

Now, monetary policy is beginning to tighten in major countries, after years of accommodative policy following the 2008 financial crisis in an effort to stimulate the economy. The European Central Bank and Bank of England have signaled they could soon depart from years of ultra-easy monetary policy. In the U.S., the Federal Reserve is already raising interest rates and plans to begin reducing its balance sheet holdings later this year.

To Matsuoka, that’s enough reason to worry about a frothy market.

Just as the effect of those stimulative measures was strongest the first time around, the initial move to tighten monetary policy “could well deliver a bigger negative effect on the financial market and the real economy” than future measures, Matsuoka said. “The US Federal Reserve appears willing to accelerate the frequency of the rate hikes, which could further amplify the negative shocks.”

— CNBC’s John Melloy contributed to this report.

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