Stocks Have Only Been This Expensive One Other Time — And The Fallout Was Bad

It’s getting tougher and tougher to find value in the U.S. stock market. By at least one popular investing metric, U.S. stocks have only been this expensive one other time in history, and things didn’t work out so well then.

According to the cyclically adjusted price-to-earnings ratio — a measure of market value based on 10 years of smoothed earnings data — the S&P 500 is at its second most expensive point in history.

The S&P 500’s current CAPE of 31.6 has only been surpassed one other time, during the peak of the Dot Com bubble in 2000. Today’s CAPE is roughly double the S&P 500’s historical mean.

Time To Dump Stocks?

Many investors still remember the painful fallout from the Dot Com bubble, but selling or shorting stocks may not be the answer.

There's good reason for stocks to be as expensive as they are, said DataTrek cofounder Nicholas Colas. Investors have few viable options in today’s global financial markets, he said. 

“The key point about the Shiller PE is therefore NOT that stocks are expensive,” Colas said in a recent newsletter. “Rather, it is that markets expect inflation/interest rates to remain low and corporate earnings to stay elevated.”

CAPE’s Shortcomings

Stock earnings have historically been discounted by a cost of capital that's tied to interest rates. Even after several rate hikes in recent years, interest rates remain historically low, a phenomenon which is not accounted for in the CAPE ratio.

While CAPE certainly gives a relative indication of market valuation, it also hasn’t been the best indicator of when to buy and sell stocks, Colas said. Since it incorporates a decade of earnings data, CAPE tends to be relatively slow-moving. Using CAPE alone, U.S. stocks still seemed expensive even after the bursting of the Dot Com Bubble and the 2008 financial crisis. On the other hand, CAPE has indicated stocks were pricey for the past five years during one of the strongest bull markets in history.

Shiller Weighs In

Even Nobel Prize-winning economist Robert Shiller, who often references the CAPE ratio as a measure of market valuation, says an expensive market doesn’t necessarily mean it’s time to dump stocks.

Back in June, Shiller said U.S. stocks “could go up 50 percent from here” and value investors shouldn’t be exiting the market even at today’s lofty levels. Yet he acknowledged that stocks are “highly priced now, which means I don’t expect them to outperform so much.”

After another incredible year of gains, the SPDR S&P 500 ETF Trust SPY is now up 17.1 percent in 2017.

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