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Here’s Why Stock Market Investors Should Be Nervous

Daily Ticker

Now that the stock market is hitting new highs, everyone's suddenly excited about buying stocks again.

Meanwhile, four years ago, when stocks were at a decade low, no one wanted to have anything to do with them.

Warren Buffett is fond of observing that, when any other item in the economy goes on sale, folks get stoked about buying it. ("It's cheap! I'm getting a deal!") When stocks go on sale, meanwhile, folks are appalled by the idea of buying them. Instead, everyone wants to wait until stocks have gone up steadily for many years and, therefore, seem "safe."

Related: 4 Reasons People Don’t Care About the Record Dow

The good news about this bizarre and return-destroying attitude is that it creates an opportunity for investors who can manage their own emotions and buy when others are fearful, as they were four years ago, and sell (or at least get cautious) when others are greedy.

And right now, after four years of amazing gains in stocks, investors are getting greedy.

Does this mean the market is about to crash?


Nothing means that the market is about to crash. Crashes are just a risk that you have to accept if you want to invest in the stock market. And for long-term investors, these crashes aren't actually a big or bad deal. They create the opportunity to invest more money in stocks at lower prices.

But investors who are now feeling comfortable with the stock market because stocks just keep going up should keep a couple of things in mind.

First, when measured on valid valuation measures--measures that take into account the business cycle and have shown an ability to predict future returns--stocks are very expensive.

As fund manager John Hussman notes this week, two of these measures--Robert Shiller's "cyclically adjusted P/E ratio" and "Tobin's Q"--suggest that stocks are about 50% overvalued.

Related: Market Is 'a Bit Bubbly' With Risks of Big Movements: Robert Shiller

This overvaluation does not mean that stocks are about to crash. But it does suggest that future returns are likely to be very low relative to long-term averages.

John Hussman estimates that stocks will only return about 3.5% per year over the next decade, which is a far cry from the 10% long-term average and the even greater returns of the past few years. So, even barring a crash, investors should keep their long-term return expectations in check.

Related: The Dow Will Surpass 16,000 This Year: Jeremy Siegel

One thing that might actually cause stocks to crash, meanwhile, is a return of corporate profit margins to their long-term averages.

Those who say today's stock market is "cheap" are comparing today's price to this year's earnings.

The problem is that this year's earnings are benefitting from record-high profit margins.

American companies have never made as much money per dollar of revenue as they are making now. And, in the past, when profit margins have spiked to levels that are even approaching today's levels, the margins have suddenly and violently reverted to the mean.

Importantly, no one sees these profit-margin collapses coming.

At some point, today's record-high profit margins will almost certainly revert to the mean.

If this happens suddenly, the way it has always happens in the past, the stock market will almost certainly crash.

Now, there are many good reasons for long-term investors to keep a healthy percentage of their portfolios in stocks:

  • Expected stock returns, however paltry, are still higher than the expected returns from bonds and cash
  • Stocks are a good inflation hedge (if inflation picks up, it can destroy the value of bonds and cash)
  • Just because stocks are "overvalued" doesn't mean they will fall, and profit margins could always go higher before they collapse.