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How a soaring stock market puts investors under the gun

Norman Rothery

Deborah Baic/The Globe and Mail

Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.

The U.S. stock market is trading at sky-high levels. So, you've gotta ask yourself one question. Do you feel lucky? Well, do ya?

I'll be exploring that question after I briefly apologize for appropriating Clint Eastwood's lines from his 1971 movie Dirty Harry. But it's a sentiment that came to mind when I was doing my year-end market review.

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Problem is, traditional valuation metrics point to bubbly conditions for U.S. stocks. I'll use Professor Robert Shiller's cyclically adjusted price-to-earnings ratio (or CAPE) to demonstrate. The S&P 500's CAPE is calculated by taking the price of the S&P 500 index and dividing it by the average of the index's inflation-adjusted earnings over the past 10 years. The idea is to smooth out the earnings cycle to get a sense of the market's earnings power.

The ratio climbed to 32.2 by the end of 2017. To put that in perspective, the median CAPE for the S&P 500 (the point where half the readings are higher and half are lower) is 16.2 based on monthly data from the start of 1881 to the end of 2017. The ratio hit more extreme levels less than 3 per cent of the time over the period.

A decline of about 50 per cent would be needed to get the market back to its median point. A crash of almost 70 per cent would be needed to push the CAPE below 10, which is all too common after significant market crashes.

We can look at what happened when the market's CAPE moved above 32 in the past. There were basically two times when it did so. The first occurred briefly in the summer of 1929 when it reached 32.4. The second occurred in the summer of 1997 as the internet bubble kicked into high gear.

You can examine the accompanying graphs which display the total returns of the S&P 500 around both periods. In each case the value of the portfolio used to track the market was set to be equal to one dollar in the month when its CAPE moved above 32. In 1929, that happened to mark the peak of the market. In 1997, the market continued to run higher before crashing in the early 2000s. Both cases are illuminating. (The returns mentioned herein are adjusted for inflation, include dividend reinvestment, and are based on monthly data from Prof. Shiller. They do not include fund fees, taxes, or other trading frictions.)

In the first case, the market fell 77 per cent from its 1929 high to its 1932 low. It briefly moved past its 1929 high in 1936 and then tumbled again in the crash of 1937. Investors had to wait until early 1945 for the market to return to its 1929 peak, which represents a span of almost 16 years.

Looked at another way, an investor who bought into the index in 1924 enjoyed the bull market only to find themselves back to where they started in 1932.

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In 1997, the situation was a little different because the "irrationally exuberant" market subsequently moved up 55 per cent to its high in 2000. Its CAPE peaked at 44.

Despite the happy run-up, investors who bought the S&P 500 in 1997 would have found their position down 14 per cent at the lows of 2003. The index recovered somewhat only to bottom out in 2009, 25-per-cent below its 1997 starting point. Instead of investing in 1997, they would have been better off to have waited for a more reasonable CAPE of 21 in 2003 or a CAPE of 13 in 2009.

This week, the S&P 500's CAPE nudged above its 1929 highs, which means investors are looking down the barrel of the market's valuation gun. For my part, I'm not feeling lucky. Mind you, the market could be bluffing like Mr. Eastwood's character did in Dirty Harry.

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