In case you’re still hiding under your pandemic rock, it’s time to come out and consider, among other things, that the stock market is currently expensive, overpriced, and overvalued.  All these terms mean essentially the same thing: share prices of companies are high relative to basic measures of their current or future value.  For example, this Marketwatch article by Mark Hulbert reviews several different stock valuation metrics including:

• The ratio of S&P 500 price over earnings, sales, or book value for the previous year (P/E Ratio, P/S Ratio, and P/B Ratio, respectively).
• The Cyclically-Adjusted Price/Earnings Ratio (CAPE Ratio) of the S&P 500 uses the average of the past 10 years of earnings.
• The Total Return (TR) CAPE Ratio of the S&P 500 is similar to CAPE but includes dividends in the calculation.
• The total dividends of the S&P 500 as a percent of index price (Dividend Yield).
• The total market cap of all publicly traded U.S. companies divided by the replacement cost of corporate assets (Q-Ratio) or the latest government estimate of GDP (Market Cap/GDP Ratio aka the Buffett Indicator).

You can read the Hulbert article yourself for details, but the bottom line is that all these measures suggest that the U.S. stock market is at nose-bleed valuation levels.  As an example, here is a graph from a website called Current Market Valuation¹ that shows the Market Cap/GDP Ratio (Buffett Indicator) since 1990.

Basically, the U.S. stock market has reached its most expensive level since this metric has been in use.

So What?

This is typically where most articles on stock valuations tend to end.  Perhaps, the author adds a few words of caution or suggestions to “take money off the table”.  Of course, for mindful investors, these platitudes are useless, because we know that timing the market is impossible, and the most productive way to invest is to buy and hold low-cost stock index funds for the long-term regardless of whether the stock market is expensive, cheap, or anything in between.

The other conclusion you’ll often see is that although suggestive, these high valuation indicators aren’t necessarily predictive of poor future returns.  Continuing with the initial example, Current Market Valuation provides this graph of how the Market Cap/GDP Ratio has performed in the past as a predictor of the next five years of cumulative returns for the S&P 500.

The overall R-squared level of this relationship is just 0.18, which suggests the Buffett Indicator is not a great predictor of future returns.  Nonetheless, there is some predictability here.  And staring at the chart, I can’t help but notice several sub-patterns in the dots that might be teased apart to generate even better predictions.

Regardless, I like a metaphor from Hulbert’s article, where he compares the market to a leaf in the wind.  You can’t predict exactly where the leaf will be an hour from now, but it will almost always be somewhere downwind of its current location.

Current high market valuations are the main reason why most professionals are predicting that the next decade of nominal stock returns will be around 5%, well below the historical average of 9%.  If you like to engage in crystal ball gazing, I summarize and annually update future stock (and bond) return predictions here.

Thinking About the Future

Rather than trying to predict exactly where the leaf will land, which is impossible, let’s instead consider a range of potential future scenarios for stock prices and valuations.  I’ll use the popular CAPE Ratio indicator created by Nobel Laureate Robert Shiller to play out some plausible scenarios for the next 10 years.

For inputs to the CAPE Ratio, we need the price of the S&P 500 index, the inflation rate, and combined earnings of the S&P 500 companies.  Shiller provides all these past data in a downloadable spreadsheet on his website.  The spreadsheet also includes his running calculation of the CAPE Ratio over time as shown in this graph (which I reformatted slightly from the one in his spreadsheet).

The green line in the graph is for the TR CAPE Ratio, which includes dividends.  TR CAPE might seem like a better measure of total valuation, but the simple CAPE Ratio is more widely used.  And since 2000, the TR CAPE has hovered around 10% above the simple CAPE Ratio pretty consistently.  That is, the simple CAPE Ratio is good enough for our purposes today, and the TR CAPE won’t show anything different on a relative basis.

From this starting point, let’s consider some plausible scenarios for the next 10 years.  You could go really crazy with this, but I dreamt up a few scenarios for the next 10 years as summarized in this table of future S&P 500 prices, earnings, and economic inflation rates.

Scenarios	Annual Nominal Price Growth	Annual Nominal Earnings Growth	Annual Inflation Rate
1. Continuation of the Last 10 Years	12%	4.8%	1.7%
2. Expected Returns with Continued Earnings Growth	5%	5%	2%
3. Pessimistic Market	0%	15%	2%
4. Expected Returns with Low Earnings Growth	5%	2%	2%

These scenarios and input values need some explanation.  Firstly, I kept the inflation rate at a sedate 2% for all scenarios because most observers expect that, due to modern Federal Reserve policies, the days of severe inflation are dead and gone.  (But given some recent worries about inflation spikes, I consider higher inflation further below.)

And here’s my rationale for the price and earnings inputs for these scenarios.

• Scenario 1 – The next decade will look like the last decade, where the S&P 500 averaged a very healthy 12% annual price growth (annualized 11.5%) and 4.8% annual earnings growth (4.5% annualized).
• Scenario 2 – Assumes annual price growth will be about 5%, which is roughly the central tendency of expert predictions², and earnings growth will be similar to the last decade (5% annual).  I couldn’t find good decadal predictions of S&P 500 earnings growth, so this is admittedly a guess as to what experts might say.
• Scenario 3 – What if earnings really take off (15% annual) for the next decade, but investors are pessimistic about the economy for some reason, so stock prices stagnate (0% annual)?
• Scenario 4 – What if investors stay somewhat optimistic (5% annual price growth), but earnings growth is lackluster as compared to the last decade (2% annual)?

My personal feeling is that something like Scenario 4 seems the most likely for the next decade.  It feels reasonable that earnings growth might slow down for a while, but I can’t see why currently exuberant investors would suddenly leave the party and drag down stock price growth.  Of course, an external event that caused a deep and sudden market crash might do the trick.  On the other hand, the 35% market drop in March of 2020 didn’t make any long-term dent in the current stock euphoria, despite the scary pandemic news at the time.

Scenario Results

Here’s a graph showing the last 10 years of CAPE Ratio (to give some historical context) and the projected results 10 years into the future for each of the four scenarios.

I’ve added to the graph some horizontal dashed lines representing past statistics on the CAPE Ratio.  Note how the CAPE Ratio average since 2000 at 26.4 is more than 50% higher than the average since 1871 at 17.2.  You can see this pattern in the historical CAPE ratio graph above as well.

(Because of the history of CAPE Ratios, some observers have suggested that modern stock valuations have attained a new plateau and won’t likely return to the CAPE levels of the last century.  Various reasons for this new era of higher stock valuations have been suggested including low interest rates.  But to me, this sounds suspiciously like the old cliche “this time it’s different”, which has often presaged painful losses in the past.)

Regardless, three of the four scenarios end up producing more expensive CAPE Ratios than today’s value of 37.  This makes sense.  If stock price growth is higher than earnings growth, the CAPE Ratio can’t come down to more historical levels.  Scenario 1, a Continuation of the Last 10 Years, seems the least plausible because it produces an astronomical CAPE Ratio of 76 over the next decade.  If that happens, investors will have thrown history completely out the window, and we will have entered some totally new investing regime.

Scenarios 2 and 4 seem plausible, where tepid markets lead to modest price growth based on decent earnings growth.  These scenarios result in the CAPE Ratio moving mostly sideways from today, although by historical standards stocks would still be very overvalued.

Only Scenario 3, the Pessimistic Market, is capable of pushing CAPE Ratios down because earnings growth is assumed to outpace stock price growth.  And despite very rosy assumptions about earnings growth (15% annual growth for 10 years straight), the CAPE Ratio descends out of the stratosphere only slowly.  It takes the CAPE Ratio about 3 years to reach its 90th percentile since 2000, about 5 years to reach its average since 2000, and nearly 9 years to reach its all-time average since 1871.  Really, only another lost decade for stocks—the first one being from 2000 to 2010—will move CAPE Ratios back in line with historical averages.

High Inflation Scenarios

Just to check what would happen, I ran the same four scenarios but changed the assumed inflation rate to 5% annual.  This certainly is no stagflation of the 1970s, but it represents a pretty high value for the next decade given the Fed’s goal to keep inflation around 2%.  Here’s a graph of the “high” inflation scenarios.

The final CAPE Ratios are a little lower, but high inflation by itself clearly won’t drive CAPE Ratios down into historical territory.  Only lower price growth and/or higher earnings growth are really capable of driving down CAPE Ratios over time.

Conclusion

While these scenarios are sobering, I’m not going to say you should “take money off the table” or any such nonsense.  Rather, the current high valuations and potential future scenarios strongly suggest we should temper our returns expectations for stocks.  With our expectations in check, we might be pleasantly surprised if the stock market somehow continues to produce excellent returns.  And likewise, we’ll be less disappointed if the stock market instead produces modest or dismal returns.  And less disappointment means we’re less likely to do something rash and start selling stocks in the next downturn.

Because current stock valuations are nearly unprecedented, it may seem like the stock market is headed for an inevitable and imminent crash.  However, I can offer two words of encouragement.  One, remember that these valuation indicators are not directly predictive of future returns.

Two, another decade of five percent or less annualized returns means something else nearly unprecedented will have happened.  As I describe more in this post, the combination of the lost decade from 2000 to 2010 followed by another decade of low returns from 2021 to 2031 would mean that the 30-year period from 2000 to 2030 would have lower annualized returns than any other 30-year period in U.S. stock market history.  And that’s true even though the middle decade from 2010 to 2020 provided unusually robust returns.

So, either continued high stock returns or reversion to low stock returns will generate something unprecedented in the next 10 years.  Who’s to say which unprecedented event is more likely?  It seems that today’s stock investors are “lucky” to be living through some exciting and unpredictable times.

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1 – This is a useful website that has similar graphs for three other commonly used market value indicators along with associated commentary.

2 – The expert predictions are for total stock returns, not just price growth.  But given that expert predictions range around a central tendency of about 5% total returns, and the current dividend yield on the S&P 500 is only 1.3%, assuming a 5% price return puts us in the same ballpark.