Can surging corporate profits be a bad thing? In the opinion of Nobel Laureate economist Robert Shiller of Yale University, investors have had an "overreaction" to the good news, propelling stocks to yet loftier valuations that are unsustainable for the long run, CNBC has reported. The CAPE ratio, a measure of stock market valuation developed by Shiller, stands at 33.30 as of Sept. 17, up about 4% since the start of the year, 97% higher than its historical mean based on data since 1881, and at its highest level since June 2001, per GuruFocus.com. Last month, Shiller told a Wharton School conference in New York, as quoted by CNBC: "We're launching a trade war. Aren't people thinking about that? Is that a good thing? I don't know, but I'm thinking it's likely to be bad times in the stock market."

Shiller has been warning about excessive stock market valuations throughout 2018, previously sounding the ominous note that his CAPE ratio has gone beyond its peak before the Stock Market Crash of 1929, and was only higher prior to the dotcom crash of 2000–2002. He recently acknowledged that he sees "irrational exuberance" in the markets, per Yahoo Finance. (For more, see also: Why The 1929 Stock Market Crash Could Happen in 2018.)

The Days of Fat Stock Returns May Be Over

Time Period S&P 500 Average Annual Total Return
Since Sept. 1871 9.1%
Since March 2009 17.3%
Shiller's Forecast 2.6%

Sources: DQYDJ.com, Barron's.

Total returns include reinvested dividends. Shiller cautions that he is not predicting an imminent market crash. However, for cumulative total returns to get back to the long-term trend, he believes that average annual total returns must plummet to about 2.6% for an unspecified number of years going forward.

"I'm thinking it's likely to be bad times in the stock market." -- Robert Shiller, Nobel Laureate in Economics

Source: CNBC.

Risks on the Horizon

There are a number of risks lurking on the horizon that could spark a drop in investor confidence, or an economic downturn that batters stocks. Central banks in various emerging market countries are tightening their monetary policies, which may cause liquidity squeezes that constrain economic growth, per another CNBC report. Escalating trade wars and trade disputes, as well as various geopolitical risks, also could harm the global economy, that report continues. (For more, see also: Why Stocks Are in a Hidden Bear Market.)

Ed Clissold, chief U.S. strategist at Ned Davis Research, warns that investors in the U.S. are underestimating risks that might arise abroad, according to a third CNBC report. However, given that "The U.S. is really a domestically oriented economy," he believes that trouble overseas is more likely to "cause a hiccup" in the U.S. stock market, rather than "be a driver of a major bear market."

Lofty Valuations

  Forward P/E Ratio Forward P/E Ratio
Stock Index At 2008 Low As of Sept. 2018
S&P 500 Index (SPX): Large Cap 9.0 16.7
S&P 400 Index: Mid Cap 8.0 16.6
S&P 600 Index: Small Cap 10.0 18.1
Russell 2000 Index (RUT) 13.0 23.7

Source: Yardeni Research; S&P calculations as of Sept. 14, Russell 2000 as of Sept. 6.

The Hindenburg Omen

The so-called Hindenburg Omen is a forecasting model that uses various technical indicators to predict the likelihood of a severe stock market decline, if not a full-fledged crash. It draws its name, and ominous imagery, from the huge German zeppelin that seemed to be the future of passenger air travel, until it exploded and burned while docking in Lakehurst, New Jersey after a transatlantic flight in 1937. Its originator, the late mathematician Jim Miekka, claimed that it correctly predicted every market crash from 1987 onwards, MarketWatch reports. While the Omen has been flashing warning signs lately, MarketWatch cautions that it has been noteworthy for raising false alarms in recent years.

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