Is the Stock Market Getting Too High?

With 9 years of awesome returns, we’re in the longest bull run in history, and the market is higher than ever before. While I’m enjoying the good vibes, I’m also worried about whether the market can handle being high as a kite.

Gauging the market’s highness using CAPE

The market is higher than it’s ever been, but a growing economy and increasing corporate profits have given it the tolerance to keep getting higher. Instead of just looking at how high the market is, we need to consider exactly what we are getting for our money in terms of earning power. The easiest way to do this is by evaluating the market’s price after adjusting for earnings using a P/E ratio.

The PE is the price you pay for a company divided by how much it earns. For example, if you pay 10 golden eggs for a goose that lays 1 golden egg a year, that goose would be able to earn its own value in 10 years, and would have a PE of 10. That’s pretty good.

Like the market, your goose’s egg production might also be erratic. There might be a 0 egg year followed by a 2 egg year. We can get a better picture of that goose’s value by looking at its average laying over 10 years. When you compare the market’s price with average earnings over the past 10 years, you get what’s called the CAPE or PE10.

CAPE data from my neighbor Robert Shiller

Adjusting for earnings, how high is the market?

Compared to the entire market history, the CAPE has also been trending higher in general. As of writing this post, here’s how the current S&P500 CAPE compares to historic averages:

  • 32.0 – Current CAPE
  • 16.9 – CAPE over market history
  • 20.0 – CAPE over last 50 years
  • 25.0 – CAPE over last 30 years

Depending on how you want to look at the data, the market could be at a “I can’t feel my legs” high, or just a little high… Of course things might be better than what the CAPE predicts.

For one thing, the last 10 year of earnings includes data from a massive recession. They also don’t have the new corporate tax cuts baked into them. If we look at more recent data like the current PE and the PE5 (with the average of the last 5 years earnings,) things look a bit better.

  • 24.6 – Current PE
  • 26.0 – Current PE5

Still, these numbers are above average, and I think it’s safe to say the market is flying high…

Now, that doesn’t mean we are headed for an imminent crash.Β  Just like someone that’s had one too many brownies, this could play out a few different ways.

The market could just couch-lock

One scenario is that the market takes a break to chill out for a while. Instead of seeing the meteoric gains we saw last year, stock prices could just keep a more mellow pace.

Things are actually looking good for the economy. Unemployment is low, and corporations just got one hell of a tax cut. If earnings continue to grow while stock prices are couch-locked, the market will sober up as CAPE returns to the mean. In this scenario, the market could just keep getting higher without incident.

Unfortunately, the market hasn’t always been so laid back.

The market might have to crash

Of course, there is a chance that the market has already bitten off more than it can chew. Maybe there are some bad student loans it wrapped in with its cheese, or maybe some skunky trade wars freak it out.Β Whether it’s paranoia kicking in, or just too much of a good thing, the market might not be able to handle this party.

In this case, the market might start stumbling around – kinda like it is now – and then crash hard. It might be a little scary, but after a good snooze, the market will be back to getting higher than ever.

While this isn’t the most graceful way to conduct business, it’s what the market has been doing since its inception. Based on the market’s history, a 50% drop in stock prices is quite possible.

The market might kiss the sky

While it might feel like stocks are stratospheric right now, the prices aren’t exactly the highest in history. Right before the dot-com crash, the CAPE reached a high of 44.

That’s the thing with the market – it’s not always rational, and sometimes it just rips. While the euphoria of hitting extreme highs might be short-lived, you wouldn’t want to sit that party out.

If the market is high, should I pull out?

I don’t want to lose half of my money, but there could be more to lose by sitting out. I’m a long-term investor for good reason. Back in 2013, I felt the exact same way about the market. From 2009-2013, the market had doubled in value. At the time, the CAPE was sitting at 22, lower than today, but well above the historic average of 16.9. To me, all the signs were saying that the market was blitzed, and an impending crash was coming.

If I had bet on what I thought was going to happen – and what I thought the market signals were telling me – I would have missed another 70% increase in stock prices. Trying to time the market – even with CAPE data – is asking for a bad time.

Now, while I’m not pulling out of the market, I am re-balancing. I have all of my investments accounts linked in Personal Capital (affiliate link) making it easy to check my allocations of stocks and bonds. If things look a little stock heavy, then I might swap some investments around to get back to my desired allocation.

Using CAPE to forecast future returns

Whether the market crashes or gets blasted into space, eventually we expect a return to the average PE ratios we’ve seen historically.

This means that the market will probably under-perform until prices sober up. Jack Bogle, the founder of Vanguard, estimates that we will only see 4% returns over the next 10 years. Meanwhile, economist blogger Big ERN, forecasts the next 10 years will see about 6% returns.

Of course, these are just forecasts. Much like how my local weatherperson can use statistical data to forecast how much snow we’ll get, it’s a well-educated guess.

Using the CAPE forecast

A while back, I wrote about my thought process on deciding whether to pay off my student loans (I’m not.) Part of that process involved evaluating possible investments. If they could return more than my loans were costing me, I’d keep my loans and invest instead. If expected market forecasts are dropping to a 4-6% range, then paying off my 4% mortgage gets more attractive.

Also, if you’re thinking about retiring while the CAPE is high, you might want to consider using a more conservative withdrawal rate.

What to do about the market being high

While my gut might tell me to pull out of the market, I’m going to stick with my investment plan, and not with what my bowels tell me.

Trying to keep my Chickenus in check

The market is made up of hard working companies that make chips, and cookies, and couches, and beer, and even deliver pizza right to your door. As long as people are still munching on those cookies, snacking on chips, watching movies, and ordering pizza, corporate profits will keep rolling in.

Just because the market keeps getting high – and crashes in the middle of parties – doesn’t mean you should bail on it. The market could be getting ready to for another meteoric session, or it might need to crash hard for a nap first. Either way, I have a feeling the market will keep getting higher over the long term. For the most part, my strategy is to ignore the data, relax, and enjoy this high-market high.

29 thoughts on “Is the Stock Market Getting Too High?

  1. Love your analogies. I want to buy the golden goose and get a steady income of one golden egg a year or would a golden chicken be better?

  2. The market is made up of hard working companies that make chips, and cookies, and couches, and beer, and even deliver pizza right to your door.

    Ha! That’s how I feel! I mean, on chips alone American could support rising market forever!

    But great analysis. If any of us knew the answer to this we’d be famous. Like you said, had we pulled back in 2013 look at the gains we would have missed out on. I’m just going to hold steady. I can’t pretend to be smarter than anyone else, that’ll just get me in trouble!

    • Agreed, I like to think I’m smart enough now to know I’m not that smart. Besides, buying and holding is efficient, effective, and stress free. Leaves time for more relaxing things than analyzing market data πŸ™‚

      Cheers!

  3. It’s really hard not to time the market or just think yup no way this could go higher. But, the math and logic of long-term investing is that you just f’ing do it. And, don’t really worry about the year to year (or decade to decade swing?)

    I’m not there yet but Jeremy and Winnie’s (of GoCurryCracker) portfolio of all stocks is so bold and simple and yet the rationale is compelling.

    • Yeah, I admire Jeremy and Winnie’s 100% stock allocation. Sure must have made for a nice ride with this bull run!

      “You just f’ing do it” pretty much sums up long term investing for me πŸ™‚

      Cheers!

  4. A well written and entertaining post Mr. CK! We don’t know how high Mr. Market is going to get before the fall, but smart investors might want to smooth-out the ride.

    Sequence of returns matter! For example — the S&P has had an average return since 2007 of about 7%. That’s great, but a 6% return compounded continuously over that time period would have beaten it.

    • Thanks, Tako πŸ™‚

      Maybe it’s all the haze up in here, but I’m not sure where you are going with that… The S&P500 annualized return since 2007 with dividends re-invested is 8.4% and that would be compounded if you were invested in an index fund… Not sure what that 6% is but 8.4% compounded would certainly be more.

      • Where are you pulling your S&P returns from?

        Joking about drug highs aside — I still stand by my statement that sequence of returns matter.

        Remember: In investing you don’t earn the average. You earn what’s called the geometric mean. Returns and losses compounded atop one another.

        The difference between the two can be quite large over time.

        • Calculating from S&P500 data on Shiller’s website, if you invested $10k in Jan 2007, it would have grown to around $24,500 in Jan 2018. This return is equivalent to annualized 8.5% returns compounded over 11 years.

          Annualized returns have all the varying compounded gains and losses baked in.

          I also found this nifty website which calculates annualized returns for you, or you can check out hypothetical growth on the Vanguard website.

  5. Isn’t this what the Godfather, aka J.L. Collins, been teaching us throughout his blogging career? πŸ™‚

    This last line encapsulates the post: For the most part, my strategy is to ignore the data, relax, and enjoy this high-market high.

    Love the art!

  6. Yes, the market is high. Yes, I will stay invested. No, I will not bail when it does inevitably drop. Yes, it will bounce back eventually or we’re all screwed regardless of our holdings in VTSAX.

    Cheers!
    Leif

    • Yep, there is a very good chance we have a 50% fall like the one in 2008. But even if you invested long term at the height of the market, right before that last crash, you would have made around 8.5% annualized returns 10 years later.

      I’ll be holding long term, there is more to lose by timing the market.

  7. Nice drawing. πŸ™‚
    What’s your asset allocation mix these days?
    I’m slowing going from 80/20 to 70/30. The market seems really high and I want to be a bit more conservative. 10% change isn’t going to make a huge difference. What do you think?

    • Thanks, Joe! The artwork helps keep this blogging hobby diversified πŸ™‚

      Right now, the allocation in our investment portfolio is around 80/20 stocks and bonds. I think the 70/30 is still a good mix. The only problem I have is the bond returns are really low. For that reason, we have been paying more towards our mortgage instead of picking up more bonds.

      So looking at the big picture, we are slowly going more conservative than what our portfolio alone shows πŸ™‚

      • Paying off your mortgage is a great move.
        I’m going more toward cash than bond. So maybe 20% bond and 5-10% money market by the end of the year.

  8. Great article and great analogies! I recently had a meeting with my 401K administrator. After I told her I was planning to retire sooner rather than later she chuckled. I guess she didn’t realize I was serious πŸ™‚ She said I was a little heavy on bonds at 20%; I was actually considering upping that haha. Or maybe putting any new money more heavily in bonds. Throwing some money at the mortgage seems like a good idea too in this situation. I was contemplating that as well.

    • Interesting that your 401k admin though you were bond heavy at 80/20. But of course that probably depends on when she thinks you might retire. I just checked the Vanguard 2030 target retirement portfolio, and right now it’s at a 70/30 split. The 2040 target fund however, is at a 85/15.

      In retrospect I should have been much more aggressive earlier in my journey, but of course hindsight is 20/20, and we all still have to sleep at night πŸ™‚

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  10. Man we just got back some $170k monies and the market looks so high that it’s making me nervous. I do think we should just throw it in because our overall finances are sound so having that money sit there does totlaly nothing.

    I LOVE YOU PICTURESSSSSSS. So cute!

    • Thanks!

      It’s definitely tougher to invest knowing the market is high, but I also felt the same way years ago. I’m glad I did invest then instead of waiting for a market dip πŸ™‚

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