Robert Shiller warned of expensive stocks in 1996 – now they are even pricier

In 1996, Nobel laureate economist Robert Shiller alerted U.S. Federal Reserve officials to the potential dangers of an overvalued stock market. He presented calculations showing that the cyclically adjusted price-to-earnings (CAPE) ratio, later known as the Shiller P/E, had only been higher once before: in 1929, just before the Great Depression. In 1996, this ratio stood at 27, a level that historically preceded significantly poor subsequent years for the market.

Shiller's concerns were shared with then-Fed Chair Alan Greenspan, who, just two days later, famously warned of "irrational exuberance" in asset markets. Greenspan pointed to Japan's prolonged market downturn as a cautionary tale. However, the U.S. stock market initially reacted negatively but soon recovered, continuing its upward trajectory. The S&P 500 was at 743.91 points on the day of Shiller's meeting with the Fed.

Four years later, the Shiller P/E ratio climbed to 44.2, just as the dot-com bubble was about to burst. By 2002, the S&P 500 had fallen significantly, though it still remained higher than its 1996 level. The index later dropped even further in 2009 following the financial crisis. Shiller's warnings proved prescient, as the years following 1996 were indeed weak for the market, although a crash on the scale of 1929 was averted.

Currently, the Shiller P/E ratio stands at 42, a level comparable to the peak before the dot-com bubble. Investors, however, have grown accustomed to such warning signs, especially since there hasn't been a major market crash in 18 years, leading to a potential complacency regarding high valuations.