When he wants, Ben Bernanke can be a real party pooper. At his quarterly press conference on June 19, the Federal Reserve chairman signaled a potentially jarring shift in the highly stimulative monetary policy that the Fed began during the financial crisis and that has helped drive stocks to new highs of late. For Wall Street, his words were a major buzzkill. Bernanke announced that the Fed might start winding down its $85 billion in monthly bond purchases later this year and end the program entirely by mid-2014, provided that the economy keeps improving, as he expects. Over the next few days stocks, bonds, and commodities all plummeted in a synchronized swoon on fears that the now four-year-old bull market would stall without constant fuel from the Fed.
Today many investors are asking the inevitable question: Is this the beginning of a major selloff or just a blip that creates a buying opportunity? Indeed, the week after Bernanke’s comments, stocks rallied. Now that the market has absorbed the bad news with minimal damage, is it time to go all-in on equities?
Unfortunately the numbers say — definitively — no. This is not a temporary reversal, but the start of a tectonic shift that will be a major negative for stocks. Over the past half-decade the Fed has deployed extraordinary measures that have driven interest rates down near the rate of inflation. That has made investors crave equities, because the yields on bonds that compete for their money stayed so unenticingly low. The Fed’s policies inflated stock prices, but below the surface, the math never worked. The fundamentals for equities — their dividend yields and earnings potential — never justified those lofty valuations. Now financial gravity is taking hold. Just as the Fed’s stimulus spurred markets, the return to normal will punish them.
Since Bernanke toughened his talk in mid-June, the yield on 10-year Treasury notes has vaulted from 1.63% in early May to over 2.5%, dropping prices by almost 7%. That’s making bonds look a whole lot more attractive compared with equities, a trend that’s bound to continue. But so far, the equity markets barely reflect the perils ahead. In the five trading days after Bernanke’s speech, the S&P declined by less than 5% before rallying. The financial math shows that stocks still aren’t cheap enough to promise more than piddling, single-digit returns. Even that scenario is optimistic. If investors become more sensitive to risk — and they might, given that today’s churning markets appear highly vulnerable to unforeseen shocks — then prices will suffer far steeper declines.
Stocks have been on a tear since bottoming out in March 2009, gaining 150% through early June. Two factors account for the surge. The first is the spectacular rise in corporate profits. From the end of 2004 to early 2012, S&P 500 earnings per share jumped 50%, to around $89, a record high. But the sluggish economic recovery provided only tepid support for the profit bonanza over the past couple of years. The primary force was the ability of U.S. companies to book modestly higher revenues while substantially paring their costs, swelling margins. And lower labor costs were key to that formula. In 2012 the Fortune 500 earned a near-record $820 billion, 60% more than in 2004, with just 10% more employees.
The second, and primary, factor is the regime of low or zero “real” interest rates. Put simply, the Fed has been juicing the stock market. “Monetary policy has dominated the equity markets more than earnings growth,” says Antti Ilmanen, a managing director at AQR Capital, which manages $80 billion in assets. “The low discount rate boosts all asset prices and is the main reason stocks have performed so well.” The historic rise in earnings and unprecedented lift from rates are highly unusual events that not only aren’t repeatable but are bound to reverse.
The major threat is the Fed’s change in policy. Rising interest rates are a downer for stocks. That doesn’t necessarily mean stock prices can’t keep growing. But it’s possible only if earnings counteract the headwind of rising rates by growing at an extremely rapid pace. Here’s why that won’t happen: Today profits already stand at near bubble levels. For 2012 the Fortune 500 generated a return on sales of 6.8%, far above the historical average of 5.6%. “When you’re at peak earnings, you’d expect profits to go back to normal, not grow fast from these levels,” says Ilmanen. Indeed, since peaking in early 2012, S&P earnings have remained flat.
Even worse, stocks today feature high prices on top of those earnings — making them more vulnerable to declines. The price/earnings multiple, based on the last 12 months of S&P 500 profits, stands at 18.4. That’s by no means cheap. But it substantially understates how pricey stocks really are. The best measure of whether equities are cheap or dear is the cyclically adjusted price/earnings ratio, or CAPE, developed by Yale economist Robert Shiller. When profits are at a cyclical peak, P/Es can look artificially low. That’s just the case today. Shiller adjusts for that problem by using a 10-year average of inflation-adjusted earnings; the averaging smoothes out the spikes and valleys and better reflects a sustainable level of profits.
Even after the recent correction, the Shiller P/E stands at 23.6. Since 1924 the CAPE has been that high less than 20% of the time. The problem is that the higher the CAPE when you buy in, the lower your future returns. Cliff Asness, co-founder of AQR, extensively studied the returns investors have garnered over 10-year periods when they bought in at different CAPEs. With a CAPE at today’s level of around 23 as a starting point, Asness has found, investors have averaged just 0.9% a year, adjusted for inflation, over the following decade — a return that would generally lag far behind government bonds.
That sobering number provides a valuable warning. But keep in mind that it’s an average, and folks fared better over many 10-year periods. So let’s consider the most favorable outlook first. If the P/E (today’s 18.4 number) remains constant — a big if, to be sure — the total return is the sum of the dividend yield and earnings growth. The current dividend yield is 2%. Over long periods earnings per share rise around 1.5% annually, adjusted for inflation. Adding the two gives a total real return of 3.5%. Include inflation of around 2%, and you get an expected return of 5.5%.
Recall that earnings are at a peak. So they probably won’t grow at even 1.5%. Chris Brightman, head of investment management at Research Affiliates, a firm that oversees strategies for funds managing $142 billion, figures that earnings will expand around 1%, which adds up to a 5% return. That isn’t bad in an environment where 10-year Treasuries, as of today, are yielding around half that number.
But, as Brightman acknowledges, there is also the very real possibility of a major correction that would drive future returns far lower. “Investors could suddenly realize that the projections for rapid earnings growth are not realistic and that the world is really a frightening place,” says Brightman. If that happens, stocks will need to get a lot cheaper to be attractive. According to Asness’s calculations, the CAPE must generally be lower than 16 for investors to expect average annual returns of 10% or more, including inflation. For the market’s valuation to get to that level, the S&P 500 index would need to fall by a third from its current level, to around 1,100. As devastating as that would be for investors, it would also be the first great buying opportunity in stocks since early 2009.
Given the possibility of a dramatic collapse, this is not the time to increase your exposure to the broad market. The risks are just too great. (For more on how to protect yourself, see Insure your stocks against a crash.) But though stocks in general are really expensive, a few choice industries offer bargains. A notable example is health care. Pharmaceutical, medical equipment, and insurance stocks haven’t joined in the epic rally, chiefly because investors fear that looming health care reform will curb profits. But it’s more likely that the big subsidies contained in the legislation will lead to even bigger revenues and earnings. The star performers in these industries typically offer dividends well above average, a commitment to repurchasing shares, and, best of all, low P/Es coupled with solid earnings growth. A good choice in pharma is Pfizer, offering a 3.4% dividend yield and a 14 P/E. In medical equipment a winner is Medtronic, with a 2% dividend and a 15.4 multiple. And an insurance stock that’s on the rise but still a bargain is UnitedHealth, with a rapidly rising dividend, 8% earnings growth, and a P/E under 13.
The byword is caution. You’ll need to save more to meet your retirement goals, given the low returns equities are promising. It’s also advisable to keep more money in cash, awaiting a rise in bond yields and possibly a fall in stock prices. Make no mistake: It’s a new era, one that may take us from “nothing to buy” to a panoply of bargains. The journey, however, could well be painful.
This story is from the July 22, 2013 issue of Fortune.