If you look closely at the last 150 years of stock market history, you’ll see a clear pattern: Periods of extremely high valuations are often followed by disappointing returns, some of which lead to outright crashes.
Right now, we’re living through one of the most expensive markets in history — the second most expensive, as measured by the Shiller cyclically adjusted price-to-earnings (P/E) ratio. Since the 1880s, the Shiller CAPE ratio has averaged about 18. At the time of writing, it had exceeded 41. Only once has the market been this expensive, and that was during the dot-com era.
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What does a high Shiller CAPE ratio actually mean?
The Shiller CAPE ratio is a handy way of evaluating the S&P 500 (SNPINDEX: ^GSPC) based on the last decade of inflation-adjusted earnings. “Inflation-adjusted” is just a technical way of saying those earnings are converted into today’s dollars; it makes the comparison more apples-to-apples. Likewise, using a decade of data helps smooth out unusually strong or weak years, which offers a much clearer picture of the market’s underlying value.
Typically, a higher-than-average CAPE ratio is a strong signal that the market is expensive. Over the last 30 years, for instance, the average CAPE ratio has been about 29; today’s reading of about 41 is exceptionally high.
What does an expensive market mean to investors?
An expensive market isn’t necessarily bad, nor does it imply that every stock within it is overpriced.
At the same time, high valuations often coincide with overly speculative periods. The speculative nature, which can detach concrete earnings from expectations, is what makes these markets particularly fearsome. Investors expect growth far into the future, leaving little breathing room for disappointment, and any threat to future profits can give the market the jitters, possibly even triggering a crash.
The dot-com crash is an example of this phenomenon. In the mid-to-late 1990s, investors were pouring money into little-known tech companies that had hardly any revenue or profits. At about the same time, the Federal Reserve started raising interest rates — three times in 1999, followed by three more in 2000.
The Nasdaq Composite (NASDAQINDEX: ^IXIC) peaked in March 2000. Then, a combination of higher interest rates and companies selling their own stock triggered panic. By October 2002, the tech-heavy Nasdaq index had fallen 78% from its peak.
