It will be seven years in December since Fed Chairman Alan Greenspan first wondered out loud whether investors in U.S. stocks were being 'irrationally exuberant'. Even though the remark centered on the role that inflated stock values would have on the real economy, investors clung to the phrase and pushed the largest U.S. stocks down over 2 percent the next morning. The pessimism didn't last long. By the end of the day stocks had recovered nearly all of their losses.

What came next, of course, were over three years of exceptional stock gains, ultimately followed by three more years of crushing losses.

Was it irrational to invest in stocks at the time of Greenspan's speech? Not if you were lucky enough to sell at the top, of course. But what if you bought stocks and held them?

An investment in the S&P 500 Index, the most widely followed measure of large stocks, earned a total return of 5.75 percent a year through the end of September, two months shy of a full seven-year holding period. That's about half of the average long-term return on stocks.

This return also falls below what seven-year Treasury bonds were yielding at the time, which was 6.1 percent. If investors knew they'd earn less than the return on safe Treasury bonds, the decision to buy stocks and hold them would be, if not irrational, then at least a bit unwise.

This argument, though, relies on the benefit of hindsight. Greenspan had only historical data when coining the phrase. But considering stock valuations at the time, he had enough to go on. In December of 1996, the price to peak earnings ratio (Popup: Why we use price/peak-earnings) was 21, a record at the time by that yardstick. The seven prior decades had only one month where the price to peak earnings rose above 20 - August of 1929.

The late 90's bull market continued, propelled partly by substance and partly by hype. Certainly earnings growth was strong and bond yields fell (until the Fed started raising rates in 1999). The hype could be measured in earnings multiples. The price to peak earnings of the S&P 500 would top out at 33 in December of 1999. In the beginning of 2000, when investors finally decided they were unwilling to take on even greater amounts of risk, the market crumbled under its own weight. By the October 2002 low, the three-year bear market had shaved the multiple to 15.

That was Then, This is Now

This year's rally has been impressive. Stocks have gained 19.5 percent this year through the middle of October. The price to peak earnings has risen with it, to 19.6. This multiple is below its level when Greenspan sounded his 1996 warning, but still soundly above the long-term average of 14. So what does a price to peak earnings multiple above 19 mean for a buy and hold investor?

The average seven-year return since 1926 has been 10.8 percent a year. This period includes booms, busts, and everything in between. It contains price to peak earnings ratios in the single digits during the early 1930's and late 1940's, as well as 1974 and 1982. It also contains the extremes near 20 in 1929, 1972, 1987 and the then-record high level of 21 in 1996.

How did stocks perform if they were bought at a price to peak earnings multiple above 19? Buying stocks at this level or above, and holding them for seven years, would have earned a return of just 4.7 percent. This is less than half the typical seven-year return of 10.8 percent (see chart).

"It's Different This Time"

Any discussion of P/Es must include the current levels of inflation and bond yields. A stock is ultimately worth the future cash flows it generates over time. If you can discount those cash flows at lower rate - because of slower inflation - then the value of those cash flows is higher. Of course, this argument assumes that slower inflation doesn't also translate into slower growth in earnings. So assuming earnings growth is not affected, slower inflation and lower bond yields might support higher P/E levels. But how much higher?

Not much, history tells us. Looking at periods where the price to peak earnings was above 19 and inflation and bond yields were below 2.5 percent and 4.5 percent, respectively, stocks had an average seven-year return of 6 percent. This is slightly higher than investing when stocks are richly priced and with no concern for the level of interest rates, but it is still significantly less than the long-term average seven year-return.

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The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).