Stocks Are At All-Time Highs, But Much Danger Lurks Beneath The Surface

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With the S&P 500 up more than 15% this year and steadily marching to new highs, the casual observer might think all is well. However, there is much turbulence brewing beneath the surface. The excess in the market is at levels not seen since the internet bubble of 2000 and nosebleed valuations almost ensure lousy returns for stocks over the next decade. This article looks at empirical data on the relationship between valuations and historical returns as well as some warning signs on why we could be nearing the end of the bull market.

Stock Market Valuations

First, let us quickly review where valuations stand. The Schiller PE (aka CAPE and PE 10) is a valuation metric that divides the S&P 500 price by the average of 10-year earnings to smooth out yearly variations. The Schiller PE currently stands at 38.2, which has only been exceed once in the past 150 years (it got to 44 at the peak of the internet bubble in 2000).  

So why should we care if the Schiller PE is nearly pushing 40? Because there is a clear inverse relationship between the Schiller PE and the subsequent 10-year stock returns. The following chart is from research published by The Brandes Institute that graphs this relationship using data from 1881 to 2018. The x-axis shows the starting PE and the y-axis shows the actual return experienced over the subsequent 10 years. The correlation is far from perfect, but the negative slope is clearly evident. At lower levels of Schiller PE (15-20) the variation in returns can be significant, but there is really no happy outcome once the Schiller PE starts to bump up against 40.

More recent research by Michael Finke shows that the correlation between the Schiller PE and subsequent 10-year returns have actually improved in recent decades. Using data from 1995 to 2020, Finke shows that the starting PE explains 90% of subsequent returns.

One of the challenges of using historical data to test the relationship is the lack of data. There simply has not been many periods in US history where the Schiller PE has gotten near 40. Fortunately, if we incorporate worldwide markets, the data set becomes much richer.

The follow chart comes from research published by StarCapital using data from 1881 to 2013 for US and data from 1979 to 2013 for 14 other European and Asian countries. StarCapital looked at correlations with subsequent 15-year real returns, but the conclusion is the same. As the Schiller PE nears 40, the expected real return over the subsequent 15 years becomes negative.

Notably, the chart includes data from Japan which significantly expands the number of high-PE data points. The Schiller PE for the Japanese index peaked in the high 60s in the late 1980s. What are the consequences of such off-the-charts valuations? The Japanese stock market still has not gotten back to levels first achieved in 1989 now 32 years later!

The Schiller PE is not the only valuation metric that is flashing red. Other valuation metrics actually show the current market as being even more expensive than 2000. The next chart graphs the ratio of the market cap of all publicly traded stocks to US GDP. The long-term average has been around 85%. In 2000, it nearly reached 150%. As of the end of June 2021, this metric is at 200%!

My point in illustrating these charts is to show the importance of starting valuations in determining long-term returns. I cringe when I hear people buying index funds blindly talking about average stock market returns of 9-10% over the long-term. The problem is we do not live the averages. The average return is only true if your starting point is an average valuation.

When your starting point is the second most expensive Schiller PE ever recorded, you do not get to experience an average return. Factoring in expensive valuations, a more realistic return is for annual returns of 3% or lower over the next decade.

Stock Market Timing

The Schiller PE is helpful in determining subsequent 10-year returns, but it is rather useless for market timing (i.e. figuring out where the top is). While a Schiller PE of 38 is associated with poor long-term returns, there is also no telling how high it can go in the short-term before it crashes.

I do not have or pretend to have the ability to time markets, but there are some warning signs I see that suggest to me we are much closer to the 8th or 9th inning of this bull market. Using past stock market bubbles as a guide, stock market peaks occur after an acceleration in returns and what famed investor Jeremy Grantham calls “the crazies.”

So what are “the crazies?” It refers to excessive speculative behavior that is clearly not justified. The current bull market finally checked off this requirement in the 1H of 2021 with the emergence of the meme stocks. A retail-investor driven frenzy, powered by social media, encouraged by commission-free trading, took the stocks of Game Stop, AMC, and others far beyond what could be reasonably justified by fundamentals. Then there is the ultimate speculation—cryptocurrencies. The success of not just Bitcoin, but even joke coins such as Dogecoin and more recently Baby Doge speaks to the level of rampant speculation. You know things are bad if we are talking about the second derivative of Doge Coin.

What about the fact that the S&P has been steadily climbing this year? Well, let us talk about the turbulence beneath the surface. If we look at when the internet bubble popped in 2000, the NASDAQ actually peaked in March of 2000. The S&P continued to climb steadily and did not peak until August of 2020. It then went on to decline 50% over the next three years. The following chart shows the NADSAQ (red line) peaking before the S&P (black line) peaked (sorry for the small text, blame Yahoo Finance).

The dot com stocks of the NASDAQ represented the most speculative aspects of the market in 2000. The most speculative part of the current market is not any stock, but cryptocurrencies. The following chart shows that Bitcoin prices peaked in April. The S&P may still be grinding higher, but there are signs some of the speculative excess may already be on the way down. 

One final point to note—market peaks are often associated with historic IPO issuance. In just 6 months of 2021, IPOs have raised over $70 billion, which is above the full year average for the past 10 years. Further, June 2021 was the busiest month for IPO listings since … wait for it …. August 2000.

With market valuations dangerously high and a number of signals flashing red, I continue to believe the prudent investor should maintain a conservative portfolio. Better buying opportunities will eventually present themselves, but you need dry capital to take advantage of them.




I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

The information in the article is provided for informational purposes only. It should not be construed as investment advice or advice on buying, selling, or other types of transactions relating to an investment in products or services, much less an invitation, an offer or a solicitation to invest.

The information in the article is provided solely by virtue of the fact that everyone will independently make their own investment decisions: the report does not take into account investment objectives, nor specific needs or financial situation. In addition, nothing in the article represents or is intended to express financial, legal, accounting or tax advice. You should consult your own investment or financial advisor before taking any actions.

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