Stocks are too expensive

May 7, 2013, 1:00 PM UTC

FORTUNE — On Friday, May 3, the S&P 500 powered past 1600 for the first time in its history. The latest surge lifted the index’s gains since the start of 2012 to 28.3% and fortified the prevailing view that this mighty market will roar far into the future.

What the optimists — almost everyone you hear in the analyst community and on business TV­­ — ignore is that the high prices the boom has generated promise lower, not higher rewards in the future.

“The returns on stocks act the same way as returns on bonds,” says Chris Brightman of Research Affiliates, developer of investment strategies for mutual funds and ETFs. “When bond prices are high, future returns on bonds, or their yields, are low. It’s the same thing with equities. When their prices are elevated, dividend yields drop, and so do the amount of retained, reinvested earnings you get for every dollar you invest.”

The math is obvious even if Wall Street won’t see it: The near-frenzy in equities is increasingly bad news for folks getting into stocks right now.

It’s important to establish that equities are actually pricey, just when the “experts” are claiming they’re cheap. Today, the price-to-earnings multiple on the S&P 500 (SPX) is 18.6 (its current price of 1620 divided by trailing, 12-month earnings-per-share of around $87 a share). That’s well above average of roughly 16 over the past century, but in line with the ratio in the last two decades.

That seemingly middling number is highly misleading. Masking the lofty valuations is a virtual bubble in corporate earnings. Since the fourth quarter of 2009, S&P 500 profits have jumped 71%. Earnings as a portion of the overall economy stand at 11%, vs. a long-term norm of 7%. In the Fortune 500 list released on May 6th, profits as a share of revenues were 6.8%, compared with an average since the mid-1950s of 5.2%.

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Another sign of stretched expectations is economist Robert Shiller’s CAPE, an acronym for “cyclically adjusted price-earnings” multiple. To smooth out the chronic spikes and valleys, Shiller calculates a 10-year average of S&P 500 profits, adjusted for inflation. The current CAPE stands at 22.3, well above the average of 19 since 1980, not to mention a norm of 16 over since 1891. The Shiller PE you buy in at is one of the best predictors of how much money you’ll make in the decade to come; the richer the CAPE, the dimmer the future.

The high multiples aren’t necessarily illogical. After all, the Federal Reserve has made it an explicit policy to lift prices of all assets, especially stocks and houses, to rouse the listless economy. When you can get a 2% dividend that goes up with inflation, and Treasuries are offering less than inflation, it makes sense that investors expect high stock prices and low yields. So the big PEs don’t necessarily have to deflate. They do, however, virtually guarantee humdrum returns from here — and that’s the sunny scenario.

Keep in mind that the high PEs, unlike big valuations in the past, are not anticipating sumptuous earnings growth in the years to come. They’re strictly a creature of the Fed policy of negative “real” interest rates, that, by comparison to bonds, makes expensive stocks a decent buy for now but foreshadows a future fraught with risk.

So from these heights, what can we expect from the stock market as a whole? Let’s start with the unusually low, 2% dividend yield. Now add expected inflation of around 2.5% that will lift earnings and the dividends paid from earnings. How about future profit growth? Normally, earnings grow with the economy, but what investors care about, earnings-per-share, don’t wax nearly that fast. In fact, EPS historically expands at around 1.5% a year in most periods, adjusted for inflation. Why do earnings-per-share show such weak performance over time? The explanation is the issuance of new shares that dilute the ownership of existing shareholders by around 2 percentage points a year. So while overall earnings track GDP, EPS trails by a wide margin.

That brings the total return to 6%. And that assumes America resumes its characteristic 3.5% pace of economic growth, far from the tepid numbers we’ve witnessed for the past four years.

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Our forecast is built on two major assumptions: The first is that earnings-per-share will keep growing at modest rates from already unprecedented levels. But profits usually “revert to the mean,” whether it’s measured by their share of economic output, percentage of sales, or another metric. EPS for the S&P 500 peaked in the first quarter of 2012, and fell for the rest of the year. It’s by no means certain the downward trend will continue, but the possibility poses a substantial danger to stock prices.

The second positive assumption is that today’s PEs stay where they are, at relatively high levels. “Volatility is the enemy of PEs,” says Brightman. The biggest threat is a surge in inflation. Right now, consumer and producer prices are tame, and investors expect them to stay that way. But if the Fed cannot exit its policy of quantitative easing without sending prices spiraling, equities will suffer.

Looming inflation is a sort of economic “tell.” It indicates that macro policy is failing, that government can no longer maintain the placid, predictable conditions that bring investors comfort. So the best we can hope for is low, steady returns that still beat bonds. The big risk is that the “new normal” in earnings and PEs isn’t normal after all, and in retrospect proves highly unusual.

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