US stocks are “extraordinarily expensive”, says Henry Blodget on BusinessInsider.com. The S&P 500’s cyclically adjusted price/earnings (Cape) ratio is 26. Only in 2007, 2000 and 1929 has the market had a higher Cape – all of which proved to be major turning points for equities.
This doesn’t mean the current market wobbles are the start of a big slide. In 1996, stocks were at this Cape level, yet the bull market continued for another four years until the Cape hit a record 44.
However, while Cape is not much help as a short-term timing tool, it’s among the best gauges of long-term returns. History shows that if you buy stocks at expensive levels, you are likely to make poor annual returns over the next decade or so.
This is because valuations have always moved in long cycles, from cheap to expensive and back again. At major bear-market bottoms, Cape fell into single digits. The last one of these was in 1982.
During bear markets, in which valuations fall to single digits, stocks can either fall, or grind sideways as earnings gradually catch up with valuations.
So given all this, whereabouts are we in the long-term bull or bear cycles? Cape has come down since the 2000 bull-market peak, but is still historically high.
Given how long valuations took to fall back to reasonable levels after the 1920s and 1960s booms, it “wouldn’t be surprising if we had another decade or more of work-out to go”, says Blodget. So, it is likely to be some time before bargain-hunters get excited about the US market.