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Why the Red-Hot Stock Market Could be Close to a Cooldown

Economists and Wall Street experts increasingly agree that the high-flying stock market is primed to descend, if not to earth, at least out of the stratosphere.

“There are many indicators showing that equities have reached a higher valuation than is consistent with changes in either underlying economic growth or revenue fundamentals,” Aaron Klein, a fellow at the Brookings Institution, told NBC News.

Image: Fearless Girl
The "Fearless Girl" statue faces "Charging Bull" on Lower Broadway in New York. Mark Lennihan / AP

The top indicator economists point to is the ratio of share prices to earnings.

“Valuations are very high by any historical standards,” said Mark Zandi, chief economist at Moody’s Analytics. “This market is vulnerable because it’s very highly valued.”

Corporate earnings are keeping up, at least so far; FactSet reported that 73 percent of S&P 500 companies came in with higher-than-expected earnings for the second quarter, above the five-year average of 68 percent.

For many investors, these earnings justify the high valuations, but this dynamic can precipitate a cycle of increasingly hard-to-meet expectations.

“When valuations are high, people expect a lot, they expect perfection, so if a company does OK but everybody expects fantastic, that disappointment could be what causes people to reevaluate,” Zandi said.

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“Stocks do look fairly expensive today,” said Jeremy Glaser, editor of Morningstar.com, who estimated that stocks at current prices are around 4 or 5 percent overvalued. While that might sound modest, he said, stocks were estimated to be 50 percent undervalued less than a decade earlier, when the market hit its trough following the financial crisis.

“When you see markets hitting new records on a pretty regular basis… if anything doesn’t go to plan, there’s not a lot of margin of safety built into the market,” he said.

Some suspect that a correction could be coming because volatility is very low by historical standards. This might sound positive, but a little bit of fear can be a good thing for market health, and its absence worries some observers.

“That shows a great deal of investor complacency,” Zandi said.

Dan North, chief economist at Euler Hermes North America, echoed this concern, pointing to the bullish skew of sentiment in recent Investors Intelligence surveys. “That’s an indicator of overconfidence, of complacency,” he said.

But there are reasons why investors might be reluctant to cash out now. Although the Federal Reserve is widely expected to raise interest rates one more time this year, the unusually long stretch of a low-rate environment has kept investors in equities because returns in fixed-income categories are so low.

The All-Important Issue of Tax Reform

While much of the focus on tax reform has centered around the expectation of lower corporate tax rates, Klein pointed out that lowering taxes on capital gains is another idea popular among Republican policymakers. Investors might be disinclined to sell and take the tax hit now if they expect legislation that would ease capital gains taxes in the near future.

Despite the dysfunction in Washington, D.C., the expectation of business-friendly legislation is going a long way to buoy investor confidence, but investing pros say things could change if Wall Street starts to question the government’s ability to deliver.

“You have to think that there’s a great deal of optimism built into stock prices,” North said. “I think things would really take a hit if we give up on healthcare and we start tax reform [and] nothing happens there. That’s going to be a kick in the teeth.”

One wild card is the looming issue of raising the debt ceiling. “If we saw another fight over the debt ceiling… that could cause a lot of turmoil in financial markets,” Glaser said. This prospect worries experts because the last significant market drop since the current bull market began its nine-year run was when 2011’s debt-ceiling showdown led ratings firm Standard & Poor’s to downgrade the U.S. credit rating.

“That’s really been the last time the markets had a significant pullback,” pointed out Joe Heider, president of Cirrus Wealth Management.

What Kind of Market Correction Could We Expect?

Barring a political or economic shock, economists aren’t expecting a drastic plunge, but say it’s reasonable to think that the market could shave off more than 10 percent.

“I think we are poised for a pause where the market might drop 15 to 20 percent,” Heider said. He cautioned against buying stocks solely on the expectation of prices rising further. “I would not be increasing equity positions at this time. If they have cash, they should hold it.”

Investment experts warn people not to try to time the market — even the pros have a decidedly mixed record of success.

“Although a correction is certainly possible at any time, it’s not anything anyone can predict with a high degree of certainty,” Glaser said.

“This could be a great time to think about your asset allocation and make sure you hold the right mix of stocks and bonds and other assets,” he told NBC News.

Investors might find, for instance, that the escalation of stock prices has left them with a portfolio too skewed towards equities.

Investors nearing retirement, in particular, should take a look at where their money is to ensure they won’t have to sell in a downturn. “You’re getting paid to take on that risk, but you’re getting paid over the long term,” Glaser said.

“If you’re a baby boomer and you’re approaching retirement, you should make sure you’re not overly invested in stocks,” Zandi said.