Stock prices continue to climb to new all-time highs even as expectations for earnings come down. These two opposing forces have caused valuations — as measured by the price/earnings (P/E) ratio — to get almost unreasonably expensive.

“The current trailing 12-month P/E ratio of 19.4 is above the three most recent historical averages: 5-year (15.8), 10- year (15.9), and 15-year (17.6),” FactSet’s John Butters observed. “Back on December 31, the trailing 12-month P/E ratio was 17.9. Since this date, the price of the S&P 500 (^GSPC) has increased by 5.9% (to 2163.75 from 2043.94), while the trailing 12-month EPS estimate has decreased by 2.5% (to $111.36 from $114.19). Thus, both the increase in the ‘P’ and the decrease in the ‘E’ have driven the increase in the trailing 12-month P/E ratio to 19.4 today from 17.9 at the start of the year.”

And as a result, it has become increasingly difficult for market bulls to justifying buying stocks using rational fundamental analysis.

Smells like ‘animal spirits’

RBC Capital Markets’ Jonathan Golub is among Wall Street strategists who have told clients that a high P/E ratio alone is no reason to sell. Apparently, that recommendation came with quite the backlash.

“In last week’s note, we laid out the case for higher multiples (favorable relative yields, generous return of capital, below average volatility) despite weaker earnings (slower GDP and trade, peaking margins),” Golub said in a note to clients on Monday. “Lesson learned … the only thing investors dislike more than a bearish argument is an optimistic one based solely on improving animal spirits rather than fundamentals.”

“Animal spirits” is a term popularized by economist John Maynard Keynes who used it to explain how emotions can drive behavior, more so than cold rational analysis.

Now, we can’t say with certainty that it is indeed animal spirits that are fueling this market. Indeed, numerous indicators of stock market sentiment would suggest the opposite. But, something is driving these prices higher, and animal spirits may explain at least some of why valuations will drift far from their long-term averages.

In a recent note to clients, Jefferies David Zervos suggested that central bankers helped ignite these animal spirits during the financial crisis with easy monetary policy. But he warned of the danger of these animal spirits getting carried away.

“When the economy enters a state like 2008–2009, some serious medicine is in order,” Zervos said. “With an unemployment rate of 10%, 9%, 8%, or even 7%, along with little evidence of future inflation risks, aggressive treatment is in order. That is a time for coddling, not for tough love. But as we approach 5% unemployment rates (and below), the mission has largely been accomplished. The game no longer requires the reviving of broken animal spirits. And if we keep pushing, as seems to be happening, the game will devolve – and animal spirits will rise to the point of frenzy. With many trophies on their shelves, players begin to believe they can’t possibly lose. So they start to do stupid things.”