Despite an eight-day losing streak that ended on Tuesday, the stock market has generally been buoyant in the opening weeks of the Trump administration. The bullish mood could be a self-fulfilling prophecy and lead to continuing gains for a while.
Yet important measurements — some of which I developed — tell us that the market is quite expensive and that investor optimism is tinged with plenty of worry. None of this tells us where the market is going tomorrow, but it suggests that some caution is advisable, and that returns over the next decade or so are likely to be constrained.
Corporate earnings spike expected
Consider first the evidence from what is often called the Shiller CAPE ratio.
What is CAPE, or the cyclically adjusted price-earnings ratio, exactly? Bear with me. This is a bit technical: It is real, or inflation-adjusted, stock price divided by a 10-year average of real earnings. It is usually measured using the price and earnings of the Standard & Poor's 500-stock index (.SPX), adjusted for inflation with the Consumer Price Index. In 1988, John Y. Campbell (now at Harvard) and I showed in a joint article that such a ratio has, since 1881, forecast returns somewhat well in the stock market. That "somewhat" is important because the ratio has its limits as a forecasting tool.
We found back then that averaging earnings over 10 years smoothed short-run or cyclical fluctuations, providing a better indicator of fundamental value. The CAPE ratio has successfully explained about a third of the variation in real 10-year stock market returns in United States history since 1881.
This is the important point: In 1988, we found that CAPE had averaged about 15 since 1881. In years when CAPE was lower than that, subsequent 10-year returns for the stock market tended to be good. In years when it was higher, the 10-year returns tended to be bad.
That's why today's CAPE is sending a troubling message. The ratio is now almost 30. Using monthly data, it has been higher only in 1929, when it reached 33, and in the few years around 2000, when it reached 44. In both instances, sharp market declines followed those very high readings. The current level of CAPE suggests a dim outlook for the American stock market over the next 10 years or so, but it does not tell us for sure nor does it say when to expect a decline. As I said, CAPE is useful, but it does not provide a clear guide to the future.
Investor sentiment is another factor, and current readings also give us cause for concern.
I have been involved in regular opinion surveys of institutional and individual investors in the United States since 1989. These surveys are undertaken and published online by the Yale School of Management. From these data, I created a Valuation Confidence Index, which is the percent of respondents who think the domestic stock market is not overvalued; a Crash Confidence Index, which is the percent who think that a 1929- or 1987-style crash in the next six months is highly unlikely; and a One-Year Confidence Index, which is the percent who think the stock market will go up in the next year. The indexes are measured in six-month intervals, and our latest data are for the six months through February, which includes the election of President Trump on Nov. 8, 2016.
Valuation confidence in February was quite low. The only time it has been lower was in the years surrounding the market peak of 2000. In February, crash confidence was quite low too, though it has been slightly lower on a number of occasions since 1989. These two indicators might seem to confirm the apparent signal of the CAPE ratio: trouble ahead. They are certainly saying that investors aren't confident that current prices are reasonable or that the market is stable.
But one metric went the opposite direction. One-year confidence is at a record high for institutional investors, and it is at the highest level since 2007 for individual investors. (That means, by the way, that in 2007, the eve of the Great Recession and financial crisis, most people had no clue that big problems were imminent.)
Focus on investing
It is hard to reconcile these results. One possible interpretation might be that respondents perceive a stock market bubble: They think valuations are high and there is a non-negligible probability of a crash. At the same time, they are hanging in because they think the Trump boom will probably last for at least another year.
That doesn't provide much reassurance. The high fraction of our survey respondents who think that the stock market is unlikely to fall in the next year may simply reflect a failure of imagination about how a Trump bull market could suddenly end. There are scores of ways, of course. Just because people can't picture a big decline doesn't mean that they won't react very badly if the market comes under real stress.
Many people appear to believe that a business-oriented president will preside over a long stock market boom. At a glance, there appears to be some precedent for this, first with the 1920 election that brought in President Warren G. Harding and Vice President Calvin Coolidge (who took over when Harding died in 1923) and then with the 1980 victory of Ronald Reagan. These elections were followed by the Roaring Twenties of 1921 to 1929 and the Millennium Boom market of 1982 to 2000.
But in both cases, during the initial election campaigns the economy was in recession and the CAPE ratio was extremely low — around 5 in 1920 and 9 in 1980.
We are in a very different situation now. The economy has largely recovered from the last recession, and CAPE shows us that stocks are now relatively expensive.
There is no clear message from all of this. Long-term investors shouldn't be alarmed and shouldn't avoid stocks altogether. But my bottom line is that the high pricing of the market — and the public perception that the market is indeed highly priced — are the most important factors for the current market outlook. And those factors are negative.
We don't know where the market will go this month or this year. It could well rise a lot. But investors should not let themselves be tempted to bet aggressively on the Trump bull market.