The Dow Jones Industrial Average broke 12,000 today to hit an all time high. The markets are rallying strong, with the Dow posting almost an 11% gain in the last 3 months. The question for investors is whether or not this trend will continue.

From a historical standpoint, it’s hard to ignore the possibility that U.S. equities are still wildly expensive from a price to earnings perspective. Robert Shiller, author of Irrational Exuberance, has long been arguing that prices in the U.S. equity and housing markets are overvalued. He has collected data on the S&P 500 index for the last 100 years and has determined that the current price level is probably unsustainable in the medium term. Professor Shiller’s data can be accessed by clicking here.

One common measure of fair value in the stock market is the price to earnings ratio; that is, the price of the market divided by its earnings. If you looks at Shiller’s time series of P/E ratios, there are only two other times in history when P/E ratios have been as high as they are right now. The first time is 1929, when P/E ratios were around 33. And 1999, when P/E ratios were at 44. We all know what happened to the equities markets in the years following those two peaks. The P/E ratio right now is around 28.

One data issue is worth considering. Professor Shiller measures P/E as the current price divided by the *average earnings in the last ten years*. The market is forward looking and it is the future earnings that really matter for price. Earnings are certainly growing quickly right now, but how long can this kind of growth last? At least historically, the lagged earnings measure has been a pretty good predictor of future changes in the market (most notably by it’s peaks at 1929 and 1999).

In order to justify today’s prices for the Dow and S&P 500, you have to believe that corporate earnings growth will be very strong in the next 5 years. This is a hard sell though, especially in the face of a slowing housing market and a Federal Reserve who claims to be an inflation fighter.

In my view, domestic equities are not a good investment right now. There are two ways their overvaluation can be corrected over time. Either the price of the market will drop substantially or earnings will continue to grow at historically high levels. The second case is unlikely given that the Fed will raise rates if inflation becomes a problem. Either way, I’d rather not be in U.S. equities right now. We may see a short-term boom in the next 1-3 years, but the long-term view certainly has to be negative.