You can buy stocks, but Keynes’s Old Maid is out there

March 20, 2014, 3:18 PM UTC
Source: Smithers & Co.

The great Bernanke-Yellen bull market, as it enters its sixth year, presents something of a paradox. On the surface, it is still gathering pace. Every other day, it seems, the S&P 500 makes a new high. The stronger-than-expected February jobs report assuaged fears of an economic slowdown, but it wasn’t robust enough to raise concerns about the Fed raising interest rates prematurely. Despite the confrontation in Ukraine and an economic slowdown in China, the vast majority of Wall Street analysts are bullish; margin debt on the New York Stock Exchange recently hit a new high. More Internet IPOs are on the way.

Dig in a bit, though, and you’ll find that some investors are getting worried. Earlier this month Seth Klarman, a veteran value seeker who founded the Boston-based Baupost Group, warned clients of an upcoming market correction from which “few, if any, will escape unscathed.” Short interest in the S&P 500 futures contract has been rising. George Soros’s Quantum Fund has been hedging its bets.

It’s no mystery why. As Klarman noted, bubble-like valuations are being attached to such stocks as Netflix and Tesla Motors. The broader market, too, has risen a long way. A couple of months ago I mentioned the cyclically adjusted price/earnings (CAPE) ratio, which is flashing amber. Another warning sign is provided by the so-called Q ratio, which compares the market value of corporate assets with their replacement cost, and which was developed by the late James Tobin, a Yale economist. As of March 6, when the S&P 500 closed at 1,877, the Q ratio was indicating that the market was overvalued by 76%, says Andrew Smithers, a London-based analyst who helped popularize the measure. The only times the market has been more overvalued were the late 1920s and the late 1990s.

To be sure, neither CAPE nor Q is a reliable indicator of where the market will go over the short term. (No such predictor exists.) But both metrics have a good record of forecasting returns over the subsequent five or 10 years, and right now they are indicating that those returns will be low, perhaps very low. Many professional investors know this, and many of them also believe — probably with good reason — that the interest rate cycle has turned for good, which can’t be positive for stocks. And yet most money managers are still pouring clients’ money into the market.

Watching what is happening, I can’t help thinking of John Maynard Keynes, the greatest economist of the 20th century. Some people see investing as an art, others as a science. Keynes, a keen speculator on his own behalf as well as a successful manager of the endowment at King’s College, Cambridge, taught us that it’s often a game played by millions of people whose interests are aligned in the short term — they all benefit if the market goes up — but not necessarily in the long term. Everybody wants to get out before the market breaks, but that’s not possible. Wrote Keynes: “For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs — a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbor before the game is over, who secures a chair for himself when the music stops.”

Old Maid is an ancient card game, the object of which is to avoid being left with a single queen. Judged by recent events, the investing version is entering its later stages. If this includes a final blowout rally, which is perfectly possible, some of the participants will make big paper profits; a few might even get to cash them in. As Keynes noted, “These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating.” If that prospect doesn’t unnerve you, go ahead and join the action. If you are interested in investing with a safety margin and locking in your gains, this would be a good time to sell.

John Cassidy is a Fortune contributor and a New Yorker staff writer.

This story is from the April 7, 2014 issue of Fortune.