SHILLER WARNS U.S. STOCKS LOOK LIKE THEY DID BEFORE 13 PREVIOUS COLLAPSES

Robert Shiller, the Nobel Prize-winning economist that teaches at Yale University, has a warning for investors: stocks today look a lot like they did at the peak before the last 13 previous price collapses. This doesn't mean stocks are going to crash next week, but it does mean investors shouldn't be complacent.

According to Shiller, the U.S. stock market is "characterized by a seemingly unusual combination of very high valuations, following a period of strong earnings growth, and very low volatility."

In a recent post, Shiller said his cyclically adjusted price-to-earnings ratio (CAPE), which helped him win the Nobel Prize for Economics in 2013, helps predict returns by comparing current prices to average earnings over the last 10 years.

Historically, in the peak months before a bear market, which Shiller defines as a drop of 20% or more, the CAPE ratio was above its average of 22.1 (the long-term average is 16). On Friday, September 22, 2017 the CAPE was at 30.57. The CAPE ratio has only been higher than 30 twice before: in September 1929, when it was at 32.56, and from 1997 to 2002 (in December 1999, it hit a peak of 44.20).

More broadly, the peak months before the last 13 bear markets occurred in 1892, 1895, 1902, 1906, 1916, 1929, 1934, 1937, 1946, 1961, 1987, 2000, and 2007. Two big stock market collapses in 1968-70 and in 1973-74 are not included because they were more drawn out and gradual.

Even though stocks are currently overvalued, Shiller does not suggest a bear market is imminent. "Such episodes are difficult to anticipate, and the next one may still be a long way off," he said.

Still, it's important to remember that the last two times valuations were above 30, it didn't end well.

Regardless, investors shouldn't get complacent just because U.S. stocks are reporting decent earnings.

Shiller notes that peak months before past bear markets also showed strong earnings growth–on average, 13.3% for the last 13 bear markets. Interestingly, at the market peak, just before the biggest stock market crash (1929), 12-month real earnings growth was 18.3%.

Shiller ends by saying that U.S. stocks look a lot like they did at the peaks before the last 13 bear markets. Of course, the CAPE ratio is not perfect in predicting a correction, because they are difficult to anticipate.

"But my analysis should serve as a warning against complacency," Shiller concludes. "Investors who allow faulty impressions of history to lead them to assume too much stock-market risk today may be inviting considerable losses."