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

By Brett Arends

We've surpassed 1929 levels

Nothing says we're teetering on the brink of World War III quite like a U.S. stock market that's even more expensive, in relation to its underlying fundamentals, than it was at the peak in 1929.

The issue isn't just the terrifying situation in the Middle East, either. The U.S. economy is also slowing, the Federal Reserve just slashed interest rates, and we face a pivotal presidential election. Oh, and China, the world's second-largest economy, is stumbling.

Yet the S&P 500 SPX index, which is the cornerstone of almost every reader's 401(k), IRA and other retirement accounts, currently sells for a higher multiple of average earnings than at almost any time in history.

The so-called cyclically adjusted or Shiller price-to-earnings ratio, named after Nobel Prize winner and Yale finance professor Robert Shiller, is currently 35. This ratio compares stock prices to the average corporate earnings of the past decade, adjusted for inflation. Shiller was awarded the Nobel Prize for economics for showing how it had been a powerful predictor of future investment returns.

The current ratio is higher than the peak in 1929 (when it hit 33), let alone the late 1960s (when it was just 22). Both proved terrible times for investors. Actually, on this measure, the S&P 500 has only been more expensive on two occasions before this summer: During the Greatest Bubble in History from 1998 to 2001, and during the post-COVID mania of 2021-22.

Both also proved bad times to be an investor.

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

As Shaggy used to say on Scooby-Doo: Yikes!

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

By this, too, we are up in the clouds. Stocks are currently valued at 190% of U.S. GDP. That's about twice the average since the 1970s.

Or consider the measure known as the Tobin's Q, coined by economist James Tobin (another Nobel laureate), which compared the market value of U.S. stocks to the supposed cost of rebuilding all these companies' assets from scratch. It, too, is at all-time record levels and about twice its historic average.

The usual riposte from Wall Street bulls goes along the lines of, "Bears have been saying that for years, and they've been wrong and missed out on massive gains." They're absolutely right. But their argument risks double-counting. On the one hand, the higher the stock market goes, the bigger its recent historic returns. Yet on the other, by definition, the higher it goes, the lower its future returns.

The argument also ignores risks as well as potential returns.

The problem for us ordinary investors isn't that the S&P 500 is definitely going to collapse, or crash, or even that it will necessarily produce terrible returns over the next five or 10 years. It's that, as the Bard of Broadway, Damon Runyon, once said, while the race isn't always to the swift nor the battle to the strong, "that's the way the smart money bets."

How much do you want to bet on this asset class, at these odds?

Mark Cecchini, a certified financial planner in Lehigh Valley, Pa., summed up the situation pretty well in a recent tweet. The "recency bias right now is so strong that no one thinks about the lost decades of the S&P," he wrote. "From 2000 to 2010, the annualized return of the S&P was -0.97% ... Personally I'm not willing to bet the probability of achieving my family's goals on 1 asset class dominated by 7 companies."

No kidding.

Those 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) - account for about a third of the entire S&P 500 by value and, even crazier, about one-sixth of all the listed stocks in the world.

At these levels, the S&P 500 seems to have priced in little margin for risk at a time when risks seem even higher than usual. The chances that it will produce terrific returns from here over the next decade must logically be slimmer than they have been.

And they are probably slimmer than most investors think. Vanguard recently reported that U.S. investors' expectations are now at their highest levels since it began surveying back in 2017. And the expectations are higher than even Vanguard's own forecasts.

Ben Inker, the co-head of asset allocation at white-shoe Boston fund firm GMO, warns in a new research paper that "lost decades" for U.S. investors - long periods of about 10 years when you earn nothing - have been more common than we may think. Inker was writing not only about the stock market but about the so-called "balanced" or "60/40" portfolio, consisting of 60% in the S&P 500 and 40% in the U.S. bond market. Since 1900, Inker writes, "there have been six periods, averaging 11 years each, in which an investor in a 60/40 portfolio would have either broken even relative to inflation or, even worse, lost money in real terms."

Everyone will have their own thoughts. Many investors, buoyed by years of a booming S&P 500 and this year's rally in bonds, will ignore the warnings and just stick with 60/40. Institutions will pin their faith in "alternatives," typically meaning high-fee entities like hedge funds and private equity. (Those are brilliant wealth creators for the people who run them. Not so much for their investors.)

Doug Ramsey at investment group Leuthold Group models an "All Asset No Authority" portfolio that has done as well as 60/40 since the early 1970s, but with no lost decades: It includes U.S. small-caps IWM, developed international stocks VEA, gold SGOL, commodities GSG and REITs VNQ, as well as the S&P 500 SPY and 10-year U.S. Treasury bonds IEF.

My own preferences include U.S. and international small-company stocks, which seem to have missed out on the S&P 500 mania; resource stocks, which seem to march to a different beat to the rest of the market; and inflation-protected Treasury bonds.

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

I don't mind interesting times. I just expect stocks to be cheaper than they are now when I encounter them.

-Brett Arends

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10-02-24 1359ET

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