It's a telling sign of the growing exuberance among investors that some mainstream commentators are now asking – without a snicker – if the S&P 500, the benchmark U.S. stock index, could nearly double from here.
John Higgins of Capital Economics published a note on Wednesday that poses the question: "Could irrational exuberance propel the S&P 500 toward 5,000?"
His answer is, yes, it's possible if history were to repeat itself. Assuming investors value U.S. stocks at the same dizzying levels they did during the dot-com bubble of the late 1990s, then the S&P 500 would rise to between 4,500 and 5,000 by the end of 2019, a huge leap from its current level around 2,840.
But Mr. Higgins does not think this is likely. In fact, he believes the S&P 500 will lose ground over the next couple of years.
Still, his explanation of this market's driving forces is illuminating for both bulls and bears. Among other things it's a reminder of how frothy markets can get.
Right now, for instance, the S&P 500 is trading for nearly 34 times its average real earnings over the past decade. This measurement, called the cyclically adjusted price-to-earnings ratio, or CAPE, has been a decent guide over the past century to the returns that investors can expect in subsequent years. A high CAPE suggests stocks are expensive and likely to produce uninspiring gains, while a low CAPE points in the opposite direction.
The market's current CAPE is the second-highest on record, which is one reason many observers predict dismal returns over the years ahead. But the market's valuation is still far below the levels reached in 1999, when the CAPE topped 44.
If you're an optimist, you can argue the market might just hit those dot-com era valuations again. If so, the S&P 500 could gain more than 70 per cent from here.
The bullish case rests on the notion that low interest rates justify sky-high stock valuations. Bonds yield so little in payoffs that investors have no choice but to buy stocks, or so the argument goes.
Mr. Higgins sees some merit in this line of reasoning, but he disputes the notion that it justifies today's towering valuations. By his estimates, current interest rates warrant a CAPE ratio of only 20 to 25 – well above the historical average of 14, but well below where stocks are now.
"We forecast that – far from soaring toward 5,000 – the S&P 500 will end 2019 lower than it is now," he says. He believes the market will be dragged down by "a slowdown in the U.S. economy, which we expect to start to become apparent later this year."
Some gauges already suggest caution. The Citi Economic Surprise index, which measures how actual readings match up against analysts' forecasts, has declined after reaching a five-year high in December. The U.S. economy is still doing well, but it is no longer bursting past expectations at the same pace it was late last year.
Meanwhile, interest rates seem to be headed up. The benchmark 10-year U.S. Treasury now yields more than 2.6 per cent, up from around 2.3 per cent a year ago.
Rising bond yields offer more competition for stocks. To be sure, that effect may be offset by stronger corporate profits, but investors may want to keep their hopes in check.
The widely followed blogger who writes under the pseudonym of Jesse Livermore at philosophicaleconomics.com recently looked at the "best-case upper limit" for U.S. stock returns over the years ahead. He started by "granting every optimistic assumption that a bullish investor could reasonably expect" in terms of valuation changes, growth in per share earnings and reinvested dividends. He concluded the highest return an investor can reasonably expect to earn from today's U.S. stocks is just under 6 per cent a year.
Just to emphasize: That's an upper limit, not an average. Also, it includes inflation, which is estimated to run about 2 per cent a year. Deduct inflation and the upper limit for what investors can hope for, in real terms, falls to less than 4 per cent a year.
Perhaps an aging population will be satisfied with such results, given the lack of alternatives. But Mr. Livermore's math underlines a disturbing fact: At the moment, investors in U.S. stocks are risking their money for some rather mediocre expected returns.
Ian McGugan