Is a stock market bubble brewing?

(MoneyWatch) With the Dow Jones industrial average continuing to set all-time highs, investors seem to finally have shaken off their fears of stocks. In January, investors poured $15 billion into U.S. stock mutual funds, the largest amount since 2004. The inflows represent a 180 degree turnaround for investors who have pulled cash from U.S. shares for the past six years. In 2012 alone, outflows for U.S. stock mutual funds were about $117 billion.

Given their track record, you might start to wonder if investor actions are again signaling that there's trouble ahead for the stock market. To see if there are legitimate concerns, we can look at a commonly used valuation metric called the Shiller P/E 10 ratio (also called the CAPE ratio or the P/E 10). In short, the Shiller P/E 10 ratio is based on average inflation-adjusted earnings from the previous 10 years. The aim is to smooth out some of the volatility of one-year price-to-earnings ratios, as P/E ratios can create a distorted view of valuations at extremes.

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A high P/E 10 ratio is considered a signal that stocks may be too expensive, while a low P/E 10 signals that stocks may be cheap. The current level of P/E 10 is 23.4, more than 40 percent higher than its historical average of 16.5. In case you're beginning to worry, in January 2000, just before the bubble burst, the P/E 10 had reached 43.8. So, we're nowhere near that territory, yet. But it's also worth noting that the P/E 10 was 24.8 in January 1996, above today's level, and the S&P 500 Index proceeded to return 26.4 percent a year over the next four years.

So what (if any) value does the P/E 10 provide? Cliff Asness of AQR provided us with the answer to that in his November 2012 paper "An Old Friend: The Stock Market's Shiller P/E." Asness found that "10-year forward average real returns fall nearly monotonically as starting Shiller P/E's increase. Also, as starting Shiller P/E's go up, worst cases get worse and best cases get weaker." Keeping in mind the current level of 23.4, and the fact that we have relatively small sample sizes, let's review the historical evidence:

• When the P/E 10 was below 9.6, 10-year forward real returns averaged 10.3 percent. In relative terms, that's more than 50 percent above the historical average of 6.8 percent (9.8 percent nominal return less 3.0 percent inflation). The best 10-year real return was 17.5 percent. The worst was still a pretty good 4.8 percent real return, just 2 percent below the average.
• When the P/E 10 was between 15.7 and 17.3 (around its average of 16.5), the 10-year forward real return averaged 5.6 percent. The best and worst 10-year forward returns were 15.1 percent and 2.3 percent respectively.
• When the P/E 10 was between 21.1 and 25.1 (it's currently in about the middle of that range), the 10-year forward real return averaged just 0.9 percent. The best 10-year forward real return was still 8.3 percent per year, but the worst 10-year forward real return was -4.4 percent per year. The cumulative loss in real terms would have been a very painful 36.2 percent.
• When the P/E 10 was above 25.1, the real return over the following 10 years averaged just 0.5 percent -- the same as the long-term real return on risk-free one-month Treasury bills. The best 10-year real return was 6.3 percent, just 0.5 percent below the historical average, but the worst 10-year real return was now -6.1 percent. The cumulative loss would have been 46.7 percent.

What can we learn from the above data? First, valuations clearly matter. In fact, they matter a lot. Higher starting values mean that future expected returns are lower, and vice versa. However, there's still a wide range of potential outcomes. Thus, it doesn't appear that the P/E 10 provides much, if any, value in being useful as a market timing tool.

However, it's very useful in setting expectations and also in building your plan and your asset allocation. Investors who are counting on stocks to continue to provide real returns of 6.8 percent are likely to be disappointed, and pension plans could find themselves underfunded, leaving problems for employees, shareholders of taxpayers.

Second, it's important not to treat the average return as the only possible outcome. It's an expected return only in the sense of being the median of a wide dispersion of potential returns. Thus, a well-developed investment plan should treat it as such. With that in mind, your plan should have what you might call "fail safe options" (such as lowering your spending or working longer) that can be exercised so that the plan doesn't fail.

If returns turn out higher than expected, you can start to take "chips off the table," gradually lowering your allocation to stocks to account for the reduced need to take risk. If returns turn out to be worse than expected, you will have well-considered options that you can exercise that will prevent your plan from failing, leaving you without the financial assets you need to support at least your minimally acceptable lifestyle. Having considered the options beforehand will also help prevent you from making decisions based on emotions that bear markets can create.

Image courtesy of Flickr user Rich Moffitt