Getty Images—iStockphoto
By Paul J. Lim
August 19, 2016

A key gauge of frothiness in the market has officially hit its highest reading since the start of the last bear market in October 2007.

While there are several ways to measure how expensive stocks are, one of the most reliable gauges compares stock prices against the past 10 years of averaged, or “normalized” corporate earnings. This particular price/earnings ratio — commonly referred to as the “Shiller P/E” after Yale economist Robert Shiller, who popularized its use — climbed to 27.3 this month.

The last time the Shiller P/E was above 27 was in October 2007, the start of the last bear market, which erased more than half of the value of U.S. equities from October 2007 to March 2009.

A Bear Market Isn’t a Certainty…

The fact is, there have been only three times in history in which the market’s Shiller P/E remained above 27 consistently — in the 2007 global financial crisis; in 1929, at the start of the Great Depression and stock market crash; and in the late 1990s, in the lead-up to the tech bubble.

To be sure, market valuations are typically viewed as a general warning signal of risk — not a precise market-timing indicator to act on immediately.

In the tech bubble, for instance, the S&P 500 index’s P/E ratio climbed above 27 at the start of 1997 — a full three years before the dot.com bubble finally burst in March 2000, marking the start of a bear market that was almost as bad as the 2007-2009 downturn.

…But There Are Still Plenty of Reasons to Worry

For starters, the bull market that began in March 2009 is now more than seven years old, making it the second-oldest bull ever.

Brad McMillan, chief investment officer for Commonwealth Financial Network, also points out that earlier this month, all three major U.S. stock market indexes — the Dow Jones industrial average, the S&P 500 index of blue chip U.S. stocks, and the Nasdaq composite index — all closed at new highs on the same day.

“That hasn’t happened since December 31, 1999,” at the height of the dot-com bubble. McMillan said. “Only in the biggest bubble of the past 70 years has that happened. And now it’s happened again.”

Moreover, even if the Shiller P/E is not signaling a bear market next week or next month, it is pointing to the strong possibility of lousy market returns over the next decade.

Vanguard, for instance, studied a variety of indicators to determine which is best at foreshadowing stock market performance in the coming decade. The mutual fund giant determined that the Shiller P/E was hands down the best tool to gauge long-term stock market performance.

Unfortunately, that’s not good news for investors.

Clifford Asness, founder of AQR Capital Management, studied past periods in which the market’s Shiller P/E rose to these levels. He found that over the subsequent 10 years, the market delivered a meager 0.5% annual returns after inflation.

To put that in perspective, the long-term historic inflation-adjusted annual return for blue-chip U.S. equities is around 7%.

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