Stock Market Risk -- Reversion to the Mean

As the stock market reaches new highs and optimism grows, it is worth considering a couple of charts that should give caution. The first one is the ratio of corporate profits to GDP. It's currently at an all-time high of 10%. That isn't going to continue. At some point it will revert to more historically normal levels. Ultimately, share prices have to be related to earnings. 

The second is the Shiller PE Ratio between share prices and trailing 10 year inflation-adjusted earnings. The Shiller ten-year P/E Ratio also suggests the market is expensive. In 2000 the ratio was 44, the highest level on record. At the top of the market in 2007, the Shiller was 27. The long-term average is 16.5. By that estimate, the stock market was 63% overvalued in 2007. Right now the Index is at 25, which suggests an overvaluation of 50%.

Overvalued assets can become even more overvalued as we saw in the 90s, but the more expensive stocks become, the higher the risk of a big drop.  About the only thing you can say with any certainty is that over the next few years there’s more risk on the downside than on the upside. Of course, you could have said that in 1997 as well. Bob Shiller did, and he missed out on a couple more years of share price inflation. Investor psychology seems to fear losing out on a big upswing more than experiencing a big loss. Certainly that was what drove real estate in the mid-aughts. But history suggests that reversion to mean is an even more powerful force.