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U.S. stocks are looking expensive, but that doesn’t mean a crash is around the corner.Getty Images/iStockphoto

Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

As we head into the new year, it's only natural to speculate about what it has in store for us. 2017 is shaping up to be an interesting one on many fronts, but my task today is to focus on the markets from the value investing point of view.

Accurately predicting where the market will go over the course of the year is, of course, a difficult task at best. But, rather than facing the challenge head on, I'm going to attack it from a few different angles.

I'll start with the S&P 500's cyclically adjusted price-to-earnings (CAPE) ratio. The ratio was popularized by Professor Robert Shiller from Yale University. It compares the index's price with the average of its inflation-adjusted earnings over the prior 10 years. The idea is to smooth out short-term earnings variations to get a better sense of the long-term trend.

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The S&P 500 traded at a lofty 27.8 times its 10-year earnings at the start of the year. That's 73-per-cent more than its median level (where half the readings are higher and half are lower) based on data from 1881 through to the end of 2016. The ratio was higher just 4 per cent of the time over the same period. As a result, it's fair to say that U.S. stocks are expensive based on this measure.

But, some observers might complain that the most recent 10-year period contains the big earnings dip caused by 2008 crash, which might skew the figures. But, if you compare the S&P 500's price with its five-year inflation-adjusted earnings, the results are only a little better. In this case, the index trades at a 50-per-cent premium to its median level and has been higher only 11 per cent of the time.

While U.S. stocks are expensive compared with their historical norms, that doesn't mean a crash is right around the corner. Rather, investors should moderate their long-term return expectations and be prepared for a market tumble.

You can think of market valuation as being akin to a long-term earthquake forecast. While geologists are virtually certain that a large earthquake will strike the western coast of North America at some point over the next few hundred years, they don't know exactly when it will happen.

When it comes to value stocks, the state of the overall market is interesting, but it might not be overly informative.

For instance, back in the late 1990s, hot high-tech stocks were all the rage and the market bifurcated into two groups. The popular stocks traded at extraordinarily high prices compared with their fundamentals, but the second group of value stocks languished at relatively low prices.

Fast forward a few years and the spread between the groups narrowed with the high-tech stocks falling a great deal while the beaten-up value stocks rebounded.

Unfortunately, the market doesn't appear to be in a particularly bifurcated state today. Instead, prices are generally high and traditional value stocks are relatively scarce.

For instance, many deep value investors like to focus on stocks that trade at less than 10 times earnings, but the pickings are slim. Only 8 per cent of Canadian stocks on the TSX currently meet the criteria while just 6 per cent of U.S. stocks fit the bill. By way of comparison, more than 42 per cent of Canadian stocks traded for less than 10 times earnings near the lows of 2009 and 20 per cent did so in 2001.

Unfortunately, that doesn't bode well for either the market or value stocks in particular.

I'm not saying that 2017 is guaranteed to be a flop for investors. It might turn out to be quite good. But risk-averse investors should think about trimming speculative positions and preparing themselves for at least a little choppiness in the year ahead.

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