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Traders on the floor of the New York Stock Exchange work frantically as panic selling swept Wall Street on Oct. 19, 1987.


Stocks are setting record highs, U.S. unemployment has retreated toward six-year lows and financial crises in North America, Europe and much of the developing world have faded.

So why is everyone so glum right now?

"I am not throwing in the towel but I'm not about to throw caution to the wind, either," David Rosenberg, chief economist and strategist at Toronto-based Gluskin Sheff + Associates, said in a blunt note on the global economy, released earlier this week.

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"This is an acknowledgment of how unusually high the level of uncertainty is."

Robert Shiller, the Nobel Prize-winning Yale economist, also stirred things up in a recent New York Times article by calling today's stock market valuations "worrisome" and comparing them to dangerous peaks in 1929, 1999 and 2007.

"Major market drops followed those peaks," he said, adding that individual and professional investors "are beginning to worry."

For some observers, worries are good. Stocks, they say, climb a wall of worry.

These observers like to point out that this has been the most hated bull market in history – defined by unusually high levels of caution and fear from the get-go in 2009, when stocks began to recover from multiyear lows.

And just look at what stocks have done with this investor reticence: Five-and-a-half years into the bull market, the S&P 500 has nearly tripled and Canada's S&P/TSX composite index hit record highs this week.

But many of today's worriers aren't bitter, sidelined investors who have missed out on spectacular gains. Rather, they are seasoned pros who have seen these conditions before and are growing increasingly concerned that the risks in the stock market outweigh the rewards.

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No one is suggesting that investors should sell all their stocks, but rather prepare themselves for disappointing returns ahead – and the possibility of the sort of demoralizing dip that can challenge our long-term commitment to the market.

'We are in an unusual period'

Mr. Shiller is about as far away as you can get from a table-pounding blowhard who sees doom and gloom around every corner.

He is a soft-spoken academic whose meticulous research draws on market data going back more than a century. In place of forecasts, he raises concerns – often with a chuckle – and his views are usually accompanied by questions and caveats.

Yet his track record for spotting trouble has raised his profile from an Ivy League professor to a voice of reason that can't be ignored.

His book Irrational Exuberance, published in early 2000, eviscerated the hokum that drove the dot-com bubble at a time when many analysts and strategists were remarkably comfortable with stocks trading at 150-times earnings.

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He showed similar prescience with his warnings about the U.S. housing market before its collapse triggered the global financial crisis and Great Recession.

In previous remarks about the stock market, Mr. Shiller has sounded cautious but hardly alarmed by stock prices – but that is changing.

His preferred approach to gauging the risks in the stock market is to compare the current level of the S&P 500 with corporate earnings averaged over 10 years and adjusted for inflation. He calls this the cyclically adjusted price-to-earnings ratio, or the CAPE ratio, which attempts to smooth out fluctuations in the business cycle.

The CAPE ratio's long-term average is about 15. But as he pointed out in his New York Times article, the ratio has risen above 25 following this summer's market surge, a level surpassed only three times since 1881.

All three just happened to occur before terrifying downturns. The crash of 1929 sent U.S. stocks tumbling 89 per cent over the next four years; the tech wreck of 2000 sent the S&P 500 down 49 per cent by 2002; and the financial crisis sent the index down 57 per cent between 2007 and 2009.

Mr. Shiller, whose article is free of bear-market gore, is not hitting the panic button. Indeed, his observations are in keeping with his here-are-the-facts approach to market timing.

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"The CAPE was never intended to indicate exactly when to buy and to sell," he said. "The market could remain at these valuations for years. But we should recognize that we are in an unusual period, and it's time to ask some serious questions about it."

Cash levels rising

Brad DeLong, an economics professor at the University of California, Berkeley, has an answer: Over the long term, it just doesn't matter. When you hold stocks for at least 10 years, it is very hard to lose money, even when the CAPE ratio is high.

In a response to Mr. Shiller, he pointed out that buying stocks at the peak in 1929 and holding for 10 years would deliver an average annualized return of 3.3 per cent, after inflation. Buying in 2007 would deliver an average return of 5.2 per cent over the next seven years. And buying in 1999 and holding on through the tech wreck and financial crisis would deliver an annualized return of 2.7 per cent.

"Thus you can see why I am relatively unsatisfied with Shiller's writing," he said in blog post.

But he warns, "if you are not an investor in the stock market for the long term, you can easily get into a world of hurt."

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Still, holding on when stocks are in freefall is no easy matter when your savings are evaporating before your eyes. Avoiding the worst of such freefalls with, say, a lighter exposure to stocks, is far less painful, which is why Mr. Shiller's warnings should resonate with investors.

Mr. Shiller is certainly not alone with his concerns about valuations. A number of investing professionals are lightening up on stocks even as the market marches higher and the S&P 500 approaches its third year without a significant correction of 10 per cent or more.

Bank of America's most recent monthly survey of global money managers found that cash levels – a buffer against market turbulence – are rising and stock exposure is falling.

As well, the same survey found that hedges against a sharp dip in equity markets over the next three months have reached their highest levels since October, 2008, soon after Lehman Brothers failed.

The respected money managers at Memphis-based Southeastern Asset Management fit right into this tilt toward cautiousness. Cash is by far the biggest holding in the $8.6-billion (U.S.) Partners Fund, accounting for nearly 26 per cent of the assets in the fund.

The managers are in no rush to invest the money: "While we are as committed as ever to identifying opportunities, we will maintain our investment discipline that has served us and other shareholders for four decades," Mason Hawkins and Staley Cates said in their semi-annual report.

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Stephen Takacsy, chief investment officer at Montreal-based Lester Asset Management, is also cautious, arguing that today's market is defined by investor complacency, a disregard for stretched valuations and distortions caused by ultra-low interest rates.

And over the longer term, he believes that massive index funds and mutual funds contribute to a market where everyone owns the same basket of stocks, much like the dot-com days of the late 1990s.

"When you add all that together, there's a big bubble forming," he said. "I'm not saying it is going to burst any time soon, but caution is warranted throughout this unusual environment."

He is prepared though: Cash levels are hovering between 5 and 10 per cent – high relative to peers – while safer dividend-generating stocks account for about 35 per cent of assets.

It is an interesting stance, given that Lester's segregated accounts have outperformed the S&P/TSX composite index and the S&P 500 over the past five years, with a total return of 140 per cent.

'Excessive valuations'

Gluskin Sheff's Mr. Rosenberg is a world-renowned economist and strategist, as well known on Bay Street as he is on Wall Street – primarily as a hard-nosed skeptic, lending irony to his nickname "Rosie."

He shed his bearish views on the market about two years ago, and he still believes that the path of least resistance for the stock market is up. However, concerns are creeping into his daily commentaries.

He noted that Gluskin Sheff, which manages $7.5-billion (Canadian) in assets, had been reducing risk in its investment portfolios, raising cash levels and trimming positions in stocks that have a heavy exposure to the economy, such as energy and consumer discretionary stocks.

"Our view is that the moderately stretched valuations in the equity market, lingering geopolitical tensions and the imminent shift in U.S. monetary policy – all these things are likely to cause some tension in the market," he said in an interview.

"Against that backdrop, we're raising some cash to put to use later in the fall at better price levels."

This caution may sound surprising to anyone who has seen some of the latest headlines on the U.S. recovery.

The economy grew 4 per cent in the second quarter, at an annualized pace, pleasantly surprising just about everyone and marking a big rebound from the first quarter. As for employment, U.S. companies generated 209,000 jobs in July, bringing the total to 1.6 million new jobs this year.

But Mr. Rosenberg digs deeper and finds little to feel upbeat about.

There is no global economic leadership, he bemoans: The euro zone is close to recession, this time dragged down by powerhouse Germany; the U.K. property market looks vulnerable and wages fell in the second quarter for the first time since 2009; Japan continues to suffer with uneven growth and China's economy is clearly slowing.

As for the U.S. economy, he called it "the smartest kid in summer school" in a recent note – that is, performing well only in a relative sense. It's not threatened by recession, but it is being held back by weak consumer and business spending. The second half of the year, he believes, will be more of the same: "Sluggish. Tepid. Lacklustre. Mediocre at best."

Five years of monetary stimulus from the Federal Reserve, he continued in his note, have accomplished little more than "excessive valuations in many asset and security markets with little, if any, economic payback … and very likely with future damage once these bubbles pop."

It's enough to make a cautious investor wonder if moving to the sidelines would be the best action right now.

But Mr. Shiller, looking at levels that make today's stock market appear eerily similar to three other historical peaks, is more interested in what's driving the lofty valuations and whether they could remain lofty for a long time.

He has no clear answers. High bond prices and very low levels of inflation might explain the interest in stocks as an attractive alternative to fixed income.

Or perhaps stocks and bonds are expensive because of people's anxiety about their financial future. That is, job losses associated with the financial crisis have pushed people to buy stocks and bonds to make up for any career-related shortfalls, even when they worry that these assets are overvalued, Mr. Shiller said.

But he is not sure. "I suspect that the real answers lie largely in the realm of sociology and psychology – in phenomena like irrational exuberance, which, eventually, has always faded before," he said. "If the mood changes again, stock market investments may disappoint us."

The most worrisome part about Mr. Shiller's warning: He has been right before.

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