Are equities too overvalued, and do they cause weakness in the financial system?

In their recent note, analysts at Capital Economics mentioned that to a number of market participants, the recent selloff in global financial markets was the start of a bigger downturn, as the valuations of many assets remain excessively high.

“However, our view is that valuations are generally not very stretched, even that of China’s stock market following its tumble,” Capital Economics said.

In some cases, valuations of assets are actually unusually low, analysts say, and while this may not preclude further falls in prices, it may “cushion the downside.”

As for China’s recent equity selloff, the firm’s chief markets economist, John Higgins, says that valuations in Chinese stock gauges, although high, have been a lot more expensive in the past. 

This, it was not significantly overvalued from a historical standpoint before its latest fall. "And the subsequent slide in the index has brought its valuation down to a ‘normal’ level,” he explains.

The Shanghai Composite Index has lost roughly 11% since the start of the month. The gauge ended down 12.5% this month, its third straight month of declines, and a close runner-up to July’s 14% loss, which was the index’s biggest monthly drop since August 2009.

“Overall, we find scant evidence to support the view that the valuations of many assets are excessively high,” Higgins says. “While this does not rule out further declines in prices, it suggests such declines are not needed.”