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May 29, 2019

European officials warn that US stocks are overpriced

The European Central Bank thinks US stocks could be in for a wake-up call.

The central bank said Wednesday in a report on risks to Europe's financial system that US stock prices appear "stretched" and may soon retreat.

"Prices seem detached from their underlying fundamentals," the ECB said in the biannual report.

Investor optimism at the start of 2019 has created a gap between markets and the outlook for global economic growth, according to the bank.

It worries that some financial assets, including American equities, are overpriced. This could lead to shocks down the line, it warned.

Stocks on notice

Market watchers have spent recent months wondering if US stocks are in for a correction.

They started the year strong, recovering from their losses at the end of 2018. Major indexes reached record highs as recently as late April.

Stocks have faltered in recent weeks amid an escalation of the trade war between the United States and China and renewed fears about global economic growth. The Dow has posted five consecutive weekly declines, the longest losing streak of that kind in nearly eight years.

But for all their volatility, US stocks remain close to peak prices. Despite tumbling about 400 points this week, the Dow is still up 16% from its December low and 6% away from hitting its all-time high.

That doesn't mean there aren't reasons for concern, some of which were outlined by the ECB.

A prolonged trade war could pose problems. Goldman Sachs analysts said recently that if the United States moves forward with threatened tariffs on all remaining imports from China, it would push the US stock market down an additional 4%.

Global economic weakness could also contribute to instability. Manufacturing in Europe and China appears weak. The chances of Britain crashing out of the European Union without a deal have increased. And the trade war could exacerbate any declines.

Then there's the yield on benchmark 10-year US Treasury bonds, which continues to drop. On Wednesday, it dipped to its lowest level since September 2017. Bond yields tend to fall when investors are worried about sluggish growth.

Taken together, these factors could put US stocks in jeopardy. The ECB warned that high valuations, along with concerns about the economic cycle, have caused a sell-off of global stocks before.

"While the December turmoil was orderly and without immediate widespread consequences, the episode illustrated that investor sentiment can prove unpredictable," the bank said.

Risks add up in Europe

Other threats to the financial system include risky corporate debt, national debt loads and weak banks in Europe, according to the ECB.

Europe's banks have fallen behind international peers since the global financial crisis, and profitability remains low. The ECB said this could hit financial stability because it limits banks' ability to build up capital buffers against unexpected shocks.

The central bank called on lenders to make structural reforms that could boost their profits. It said they should focus on businesses that include more regular, fee-based income, which typically refers to wealth management or providing financial services to corporations.

Europe's banks have long claimed to be making such changes. But whether they can do enough to spur real turnarounds remains to be seen.

Deutsche Bank, Germany's largest lender, said at its annual shareholder meeting last week that it's going to make "tough cutbacks" to its investment banking division, which trails behind US competitors and eats up significant resources. But analysts don't expect the bank to pursue a more dramatic overhaul in the near term.

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