The ascent of U.S. stocks to new record levels is partly the result of lofty valuations. In fact, valuation are now at about the same level as they were 21 years ago, when Federal Reserve Board Chairman Alan Greenspan warned of "Irrational Exuberance" in the stock market, CNBC reports. This observation is based on the cyclically adjusted price-earnings ratio (CAPE), also known as the Shiller P/E ratio after its formulator, Nobel Laureate in Economics Robert Shiller of Yale University.

Setting monetary policy against a backdrop of extreme valuations in the stock market will be a priority for the next Fed chief chosen by President Trump. The only time valuations were higher were during the 2000 dotcom bubble and just prior to the 1929 stock market crash that led to the worst recession in American history, the Great Depression. Whoever the next Fed chief may be, that person will have to steer a careful course between keeping the market frothy with rate increases that are too modest, and suddenly popping the market bubble with overly rapid rate hikes. (For more, see also: Bull Market's Best Friend Is Yellen Among Fed Picks.)

Source: CNBC

The Tale of the CAPE

Shiller's CAPE ratio compares the value of the S&P 500 Index (SPX) to average inflation-adjusted earnings of its constituent companies during the prior 10-year period. Its current value is at 31.43, per CNBC. Other, more commonly-used, measures also indicate that current stock valuations are excessive. For example, the forward P/E ratio on the S&P 500, which compares the index to analysts' projection of earnings during the next 12 months, is earnings at 17.9, per data from FactSet Research Systems cited by CNBC. By comparison, the average value of this indicator was 15.6 during the past five years, and 14.1 during the last 10 years, per the same sources.

Shiller Sees Upside

Despite having expressed concern since early in the year about overvalued U.S. equities, Shiller nonetheless admitted recently that the markets may have further upside potential. Investor psychology is a big reason, he says, and that upbeat mood is being sustained by a strong "pro-business narrative" coming out of the Trump White House. (For more, see also: How Dow 26,000 Could Come Sooner Than You Think.)

Additionally, rather than dumping stocks entirely, Shiller has suggested that U.S. investors should diversify into international markets with lower valuations. In fact, of stock markets in 26 countries recently analyzed using the CAPE methodology, Russia was the one with the lowest valuations, per an earlier CNBC report. This corresponds with recent advice from various investment professionals who also suggest diversifying internationally, in addition to upgrading U.S. stock holdings to higher quality companies. (For more, see also: How to 'De-Risk' Your Stock Portfolio For A Crash.)

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