Federal Reserve chair Janet Yellen caused quite a stir recently when she said that stock valuations were “generally quite high.” She has reason to say so. The Dow Jones Industrial Average and the Standard & Poor’s 500 have set all-time highs while the Nasdaq Composite is flirting with a record close as well. But are stocks overvalued?

While Yellen may not be sounding blatant warning bells of impending doom and gloom, reminiscent of former Fed chairman Alan Greenspan’s “irrational exuberance” speech in 1996, Wharton experts note that she may be waving yellow cautionary flags as her language has gotten stronger over the last few months.

Joao Gomes, Wharton finance professor, believes Yellen’s comments were meant to prompt people to “reassess their tolerance to risks and rethink how much exposure they have if there are hiccups” in the stock market, as the Fed prepares to raise interest rates. She “will try to start talking down the stock market a little bit. There is an element of protection, of natural self-preservation,” he adds.

Little Market Reaction

The impact of Yellen’s statement on the stock market was not exactly seismic. The S&P 500 experienced a small blip, dropping 0.78% on the same day, though major averages declined slightly.

This was a far different scenario than on December 5, 1996, when Greenspan cautioned against investor enthusiasm getting ahead of stock market fundamentals. He said, “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions” as were seen in Japan’s stock market? His comments lead to a major market sell-off. But it would take another four years for the dot-com bubble to burst.

“The Dow Jones Industrial Average can reach 20,000 by the end of the year.” –Jeremy Siegel

“Yellen’s warning seems milder than Greenspan’s comments of nearly two decades ago,” notes Krista Schwarz, a Wharton finance professor who previously worked at the Federal Reserve. “That said, whatever immediate attention Greenspan got, the bubble didn’t burst for another three to four years. The fact that the bubble kept going for so long is a clear sign that, as Keynes said, markets can remain irrational longer than you can remain solvent.”

Gomes adds, “When Greenspan warned people, it was in uncharted waters. The market was going up for so long and no one knew what was happening. The good news is we have been here a couple of times before. The reason she warned us right now is there is a serious threat to the recovery of the U.S. economy if the stock market crashes. It’s their responsibility to warn us.”

What’s up for debate is whether stock valuations are so elevated that we will see a market crash. According to Itay Goldstein, Wharton finance professor, “Anyone with experience in financial markets realizes it is quite hard to predict future price changes…. Having said that, there is no doubt that the stock market is quite high. There is also little doubt that the lack of investment opportunities pushes many people to the stock market, contributing to high prices.”

Whether we are experiencing a bubble may not be clear right now. Yellen herself says she does not see any bubbles forming, according to Reuters. “Social media and biotech are areas where valuations seem especially stretched. Yellen has specifically made this point” about smaller firms last summer, notes Schwarz.

When a large number of businesses that do not make any money go public, it can indicate a potential bubble, says Ian D’Souza, New York University professor of behavioral finance. He notes that right now, around 80% of IPOs are from companies that lose money, which is similar to the trend prior to the 2000 dotcom crash. However, he explains that bubble-busts usually occur from an intrinsic connection between valuations, human psychology and liquidity, including interest rates, and are not dependent on just one factor.

At least, we are not seeing a housing bubble, similar to the one the market experienced from 2000 to 2006, according to Jack M. Guttentag, Wharton emeritus professor in finance who runs a consumer advocacy website about real estate. Real-estate bubbles are not connected to the stock market, he adds.

“The bubble during 2000 to 2006 that led to the financial crisis was supported by a long record of house-price increases interrupted by only occasional and short-lived declines in specific areas. Rising home prices convert almost all mortgage loans into good loans. But we know now that home prices can indeed decline, so this mistake will not be made again anytime soon,” he notes.

Less Euphoria, More Fear

Currently, the price-to-earnings (P/E) ratio of the S&P 500 for the forward 12 months is around 18, the highest level in a decade. Valuation has risen since 2014, when the P/E ratio was 16.2, as earnings have fallen by more than 3%, according to MarketWatch. In terms of trailing P/E ratios, the S&P 500 is at 18 as of May 22, way above the median of 15 since 1917.

Schwarz notes, “Historically, there is some tendency for high P/E ratios to be followed by low returns over subsequent years, but it is far from perfect. Today, P/E ratios are moderately high. That suggests somewhat lower-than-average returns going forward. It could presage a big sell-off, but more likely a period of low — but positive — returns.”

“[Moderately high P/E ratios] could presage a big sell-off, but more likely a period of low — but positive — returns.” –Krista Schwarz

Robert Shiller, professor of economics at Yale University and a Nobel laureate, agrees with Yellen that stocks are overvalued right now. “The U.S. stock market has been this high only three times before since 1881,” he notes, citing the Great Depression, 1996 to 1999 during the dotcom bubble and 2004 to 2007 before the housing bubble burst. “The suggestion is that the market might do very well for a while, and then crash,” he adds.

Using a ratio Shiller developed called the Cyclically-Adjusted Price-Earnings (CAPE) measure, he looked at current stock prices relative to earnings over the past ten years in real terms. Shiller says that while the average CAPE ratio since 1951 has been 19.1, the current ratio is around 27 — more than 40% above the average.

He does, however, caution that today’s situation “seems qualitatively different” with less euphoria and “more fear of secular stagnation…. You might say the stock market is in a ‘reasonable range,’” given the low long-term interest rates. However, the “outlook is for increases in long-term rates,” he points out.

Other experts believe the market has further to go. Wharton finance professor Jeremy Siegel predicts that “the Dow Jones Industrial Average can reach 20,000 by the end of the year.” He adds: “Stocks can’t be valued on P/E ratios only; you need to look at interest rates.”

Furthermore, he says, the recession-era March 2009 numbers “ended the worst bear market in 75 years. Just because stocks have gone up dramatically from that low doesn’t necessarily mean the market is now overvalued.”

When Interest Rates Rise

The stock market will be watched closely when the Fed raises interest rates, which Wharton experts expect to happen before the end of the year. Rates have been close to zero since December 2008, which Yellen herself has called “an unthinkable six-plus years,” according to The New York Times.

“The U.S. stock market has been this high only three times before since 1881.” –Robert Shiller

According to Schwarz, “If the Fed begins a very gradual normalization of rates later this year, as I expect, that [could be] neutral for stocks. If the Fed were to tighten much more aggressively, that would likely end the current bull market.” Siegel adds, “There may be a stock correction by 5% to 10% if the Fed raises interest rates before September.”

In recent years, there has been a “lack of alternatives for investors; even bond prices are high,” notes Shiller. “The bigger puzzle is the bond market…. There may be a sharp drop in the bond market in the next few years, but if that happens, there may be an even bigger drop in the stock market.”

Where Else To Invest?

“I would call the U.S. stock market just about the priciest in the world … whose CAPE ratio is unusually high by world standards. It is reasonable to diversify across asset classes and around the world,” says Shiller. Gomes adds, “I view European markets [as being] undervalued in perceived risks. You can make a moderate adjustment to decrease exposure to U.S. stocks and increase exposure to Europe.”

Kent Smetters, Wharton business economics and public policy professor, cautions against guessing “if markets are overpriced or underpriced…. Instead, I try to focus people on having the correct amount of savings and asset allocation consistent with their goals.”

Some analysts say the lofty stock valuations have been supported by an unusually long period of low interest rates, a situation that is expected to change soon.

Gomes notes, “The real question going forward is whether the projected growth rate is going to materialize or not. Most people think it’s not unreasonable to think a 3% to 4% growth rate will happen in the next couple of years. As long as interest rates go up slowly, it’s perfectly reachable.”