The S&P 500 is almost never that expensive. It’s a disaster waiting to happen.

By Brett Arends

We have exceeded the level of 1929

There is no indication that we are teetering on the brink of World War III, any more than the US stock market, which is even more expensive relative to its fundamentals than it was at its peak in 1929.

The problem is not just the terrifying situation in the Middle East. The US economy is also slowing, the Federal Reserve just lowered interest rates and we have a crucial presidential election ahead of us. Oh, and China, the world’s second-largest economy, is stumbling.

Yet the S&P 500 SPX, the backbone of almost every reader’s 401(k), IRA and other retirement accounts, is currently trading at a higher multiple of average earnings than almost ever in history.

The so-called Cyclically Adjusted Shiller Price-to-Earnings Ratio, named after Nobel Prize winner and Yale finance professor Robert Shiller, is currently at 35. The ratio compares stock prices to average corporate earnings over the past decade, adjusted for inflation. Shiller received the Nobel Prize in Economics for demonstrating how successfully he predicted future returns on investments.

The current rate is higher than the peak in 1929 (when it reached 33), let alone in the late 1960s (when it was just 22). Both proved to be terrible times for investors. In fact, on this measure, the S&P 500 has only been higher twice before this summer: during the biggest bubble in history in 1998-2001 and during the post-pandemic mania of 2021-22.

Both of them also proved that these are not good times for an investor.

Check out this chart from Mindful Advisory, a New Jersey-based money management firm. Using Shiller’s own data, it tracks all monthly, cycle-adjusted PE rates since 1881, from cheapest (bottom left) to most expensive (top right).

As Shaggy said in Scooby-Doo: Yikes!

This is not an isolated indicator either. Warren Buffett used to say that his favorite measure was to compare the market value of all U.S. stocks to the annual U.S. gross domestic product.

Thanks to this, we are also in the clouds. The stock is currently valued at 190% of US GDP. That’s about twice the average since the 1970s.

Or consider a measure known as Tobin’s Q, invented by economist James Tobin (another Nobel Prize winner), which compared the market value of U.S. stocks with the supposed cost of rebuilding the assets of all those companies from scratch. This is also at an all-time high and is about double the historical average.

The typical retort from Wall Street bulls is this: “The bears have been saying this for years, but they were wrong and missed out on huge gains.” They are absolutely right. However, their argument may be double counted. On the one hand, the higher the stock market goes, the greater its recent historical gains. On the other hand, the higher it rises, the lower future profits will be.

This argument also ignores the risks and potential rewards.

The problem for us, ordinary investors, is not that the S&P 500 will definitely fail or crash, or even that it will necessarily deliver terrible returns over the next five or ten years. The point is that, as the bard of Broadway, Damon Runyon, once said, although the race is not always won by the fast and the battle is not always won by the strong, “that’s what smart money bets on.”

How much are you willing to bet on this asset class at these rates?

Mark Cecchini, a certified financial planner in the Lehigh Valley, Pennsylvania, summed up the situation quite well in a recent tweet. “Right now, the recency bias is so strong that no one is thinking about the lost decades of the S&P,” he wrote. “From 2000 to 2010, the S&P annual return was -0.97%… Personally, I am not willing to bet the likelihood of achieving my family’s goals on 1 asset class dominated by 7 companies.”

I’m not kidding.

These seven companies – Apple (AAPL), Amazon (AMZN), Microsoft (MSFT), Nvidia (NVDA), Google/Alphabet (GOOGL) (GOOG), Facebook/Meta (META) and Buffett’s Berkshire Hathaway (BRK.A) ( BRK.B) – make up about one-third of the entire S&P 500 Index by value and, even crazier, about one-sixth of all listed stocks in the world.

At these levels, the S&P 500 appears to have priced in a small margin for risk at a time when risk appears even higher than usual. Logically, the chances of this generating great returns over the next decade will be lower than before.

And they’re probably slimmer than most investors think. Vanguard recently reported that U.S. investor expectations are now at their highest level since the survey began in 2017. And these expectations are higher than even Vanguard’s own forecasts.

Ben Inker, co-head of asset allocation at Boston-based fund firm White Shoe, GMO, warns in a new research paper that for American investors, “lost decades” – long periods of about 10 years when you earn nothing – are more common than we might think. Inker wrote not only about the stock market, but also about the so-called a “balanced” portfolio, i.e. “60/40”, consisting of 60% in the S&P 500 and 40% in the US bond market. Inker writes that since 1900, “there have been six periods, each lasting an average of 11 years, during which an investor with a 60/40 portfolio either broke even relative to inflation or, worse yet, lost money in real terms.”

Everyone will have their own thoughts. Many investors, buoyed by years of the S&P 500 boom and this year’s bond rally, will ignore the warnings and simply stick with 60/40. Institutions will rely on “alternatives,” typically meaning high-fee entities such as hedge funds and private equity. (These are brilliant wealth creators for the people who run them. Not so much for their investors.)

Doug Ramsey of investment group Leuthold Group models an “All Asset No Authority” portfolio that has performed well in the 60/40 range since the early 1970s, but without the lost decades: includes US small-cap IWMs, developed international VEA stocks , SGOL gold, GSG Commodities and VNQ REITs, as well as S&P 500 SPY and IEF 10-year US Treasuries.

My personal preference is for small-cap stocks in the U.S. and around the world that seem to have missed out on the S&P 500 mania; commodity stocks that seem to have a different rhythm than the rest of the market; and inflation-protected treasury bonds.

Make of it what you want. It’s your money and your choice. If the S&P 500 goes vertical from here, you can have a laugh at my expense.

I don’t mind interesting times. I just expect the stock to be cheaper than it is now when I see it.

-Brett Arends

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24/10/1359ET