If this isn't a bubble, you have more to worry about

The danger of high share prices has been learned – and re-learned – throughout financial history. Yale economics professor Irving Fisher, for example, made a name for himself in 1929 by declaring that stocks had reached a ‘permanently high plateau'. The market crashed 13 days later.

It's impossible to read the business news these days without being carpet bombed with the word ‘bubble'. You may be wondering whether markets are due for another crash. Unfortunately, you won't be able to answer that question by reading the news, or asking an expert, or anybody else; it can only be known with the clarity of hindsight.

What concerns me, however, is that this isn't a bubble – that stock valuations have indeed reached a ‘permanently high plateau', due to permanently low interest rates or some other factor.

If there's one universal law of investing, it's this: every stock is a claim on a future stream of cash flows. It follows, then, that the price you pay for a stock and the return you get are two sides of a seesaw. As share prices increase relative to that stream of cash, your return on investment goes down.

Gross domestic product, or 'GDP', is a proxy for a country's output – all the services and goods produced – and Australian GDP growth has been remarkably consistent. Historically, it has stayed around the 2–4% range, in real terms, and given the stability of fundamentals that power GDP growth – population growth and productivity improvements – it's reasonable to assume Australia's economy will continue to grow at around this rate.

That being the case, the cash flows produced by Australian businesses will probably keep growing in the low-single digits, despite the inevitable ebb and flow year-to-year. The important thing to remember is that share prices bounce around far more than underlying earnings.

Market purgatory

Here lies the problem: holding that stream of cash flows constant, you can 'justify' today's higher valuations because interest rates are low (you 'discount' the cash flows at a lower rate, in analyst jargon). However, bubble or not, the universal law of investing still holds – you are accepting a lower rate of return. What you can't do is say that valuations will remain high forever, and simultaneously assume that your returns will look like the historical average.  

In March 2009, the ASX All Ordinaries Index had a price-earnings ratio of 10, while the average of the past 30 years has been around 15. Today, it's closer to 19 – we're paying twice what we were per dollar of earnings than in 2009. Long-term growth rates haven't changed much, only the fear and greed of investors.

If retirement is a long way off for you, whether or not valuations remain where they are today will make a huge difference to your nest egg.

On average, ASX-listed stocks pay out a good 75% of earnings. Let's assume, then, that an average price-earnings ratio of 15 – which implies an earnings yield of 6.7% – would produce a dividend yield of around 5.0%. Likewise, a price-earnings ratio of 19 – which implies an earnings yield of 5.2% – would lead to a dividend yield of 3.9%.

Roughly speaking, if you buy a stock with a dividend yield of 5% and the stock's earnings grow at 3% a year, your long-term return will be around 8%. If, on the other hand, you buy it with a yield of 4% and earnings are still set to grow at 3%, your return will only be 7% or so. That 1% difference may not sound like much, but if you're in your 20s, just starting out, your retirement fund could be 25% smaller if you consistently invest at returns of 7% instead of 8%. 

Even those with existing portfolios would feel the sting of persistently high valuations. Imagine you're a 40-year-old with $200,000 worth of stocks, saving $10,000 a year, with 25 years to retirement. If stocks crashed 20% tomorrow it would clobber your existing portfolio – but it would also enable you to invest at 8% thereafter.

On that basis you'd have about $1.8m at retirement, producing an income of around $90,000 (based on the 5% dividend yield).

Alternatively, if the crash never came and you were only able to invest at 7% a year, your portfolio would reach around $1.7m – $100,000 lower. Furthermore, based on our 'high valuation' dividend yield of 4%, it would produce income of only $68,000 a year.

So in the crash scenario, you'd end up with a retirement income more than 30% higher.

With this in mind, the younger you are, the more you should hope that this bubble – should it exist – pops sometime soon. It might hurt in the short term, but the pain would be far worse if valuations remain at a 'permanently high plateau'.