Experts are warning that rich stock valuations mean investors should be on guard for a possible stock market drop.
For instance, Morningstar StockInvestor Newsletter Editor Matthew Coffina
points out that the Shiller price-earnings (P/E) ratio is approaching a frothy 26.5.
"Historically, Shiller P/E ratios above about 25 have been associated with poor subsequent five-year total returns and an elevated risk of a material drawdown," he cautions.
The ratio, which uses a 10-year inflation-adjusted earnings in the denominator has been this high only three times before: the 1929 crash, the dot-com crash and the 2008 financial crisis.
"However," he qualifies, " that doesn't mean the market is necessarily headed for a crash, or even that stocks are unattractive as an asset class. First, a moderately overvalued market can still deliver strong total returns for years. "
Just look at the late 1990s and early 2000s. High valuations and total returns continued for several years before the bubble finally popped.
Plus, valuations can fluctuate and there's no guarantee the future will copy the past. For instance, the median Shiller P/E ratio was 14.1 from 1888 to 1988, but was 23.5 for the next 25 years.
Also, the ratio may gradually decline as companies' intrinsic value increases due to rising earnings.
But don't expect outstanding increases in returns, given that the market is already fully priced, Coffina advises. Instead, look for mid- to high-single-digit returns in the long run, "with plenty of bumps along the way."
Sure, opportunities still exist, he says. But be careful not to reach too far and sacrifice quality.
"Over a long enough investment time horizon, common stocks are almost certain to outperform bonds and cash, especially considering current interest rates."
Others doubt stocks' prospects for returns over the long run.
"Investors are now paying a very high P/E for the stock market, and that's usually a bad sign for their returns over the long term," Cliff Asness, co-founder of asset management firm AQR Capital, tells Fortune magazine
Stock proponents argue that stocks are providing better returns than bonds are, but that situation will continue only if interest rates remain extremely low.
"That view is basically a 'this time it's different concept,'" Chris Brightman, chief investment officer of Research Affiliates, tells Fortune. "The danger is that the Fed tightens, rates rise and, as usually happens when rates rise, P/Es fall sharply."
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