Our view that the market is fully valued at the end of the third quarter is supported by the Shiller P/E ratio, which stands around 26.5. Historically, Shiller P/E ratios above about 25 have been associated with poor subsequent five-year total returns and elevated risk of a material drawdown.
But that doesn't mean the market is necessarily headed for a crash, or even that stocks are unattractive as an asset class. First, a moderately overvalued market can still deliver strong total returns for years. Second, normal valuation levels can fluctuate significantly over time, and there's no guarantee that the past will be an accurate gauge of the future. Lastly, we can't forget the potential for growth in intrinsic value. Over a long enough investment time horizon, common stocks are almost certain to outperform bonds and cash, especially considering current interest rates.
Even so, stock investors would be wise to moderate their return expectations. Click here to read more from our Stock Market Outlook.
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