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The S&P 500 hit a new high on Wednesday and valuations are looking stretched – but investors don’t seem to see a correction ahead.Brendan McDermid/Reuters

If you've lost track of the number of times the S&P 500 has hit a new record high this year, and don't care, then perhaps you are on side with observers who suspect the market is in the early stages of a "melt-up."

That is, the market could be floating higher as it diverges from fundamentals.

Curiously, this concern has attracted both bullish and bearish observers, including Bank of America's Michael Hartnett, Ed Yardeni, and GMO's Jeremy Grantham.

While the ride higher during a melt-up is rewarding, complacent investors could face yet another disastrous downturn when it ends some time in the near-future, on par with the tech wreck and the financial crisis.

Evidence of a melt-up is becoming hard to ignore. The S&P 500's gains during the bull market are rapidly approaching 200 per cent after hitting a new high of 1,987.01 on Wednesday.

Valuations are stretched, given that the index has risen at a faster pace than corporate earnings. Its price-to-earnings ratio has moved up to 18.4, according to Bloomberg News – up from 17.2 at the start of the year and well above its 10-year average of 16.3.

Perhaps more alarming, the index hasn't endured a full-on correction of 10 per cent or more in about three years; and the CBOE Volatility index – or VIX, a popular fear gauge – remains below 12, or near its lowest level of the past decade, suggesting investors see little chance of a correction coming any time soon.

For Mr. Grantham, the source of this confidence is extraordinary monetary policy from the U.S. Federal Reserve, in the form of interest rates parked at near zero per cent and a lack of concern over what cheap borrowing costs are doing to asset prices.

"[Fed chair Janet Yellen] will not use interest rates to head off or curtail any asset bubbles encouraged by the extremely low rates that might appear," he said in his latest quarterly letter to clients. "And history is clear: Very low rates absolutely will encourage extreme speculation."

He suspects that a bubble will inflate the S&P 500 to 2,250 – or an additional gain of more than 13 per cent from today's level – driven by an explosion in the number of financial deals as companies exploit the low cost of debt, high profit margins and an expanding economy.

"This of course will help push the market up to true bubble levels, where it will once again become very dangerous indeed," Mr. Grantham said.

Mr. Yardeni, chief investment strategist at Yardeni Research, is also concerned about a potential melt-up, particularly after the S&P 500 hardly reacted to patchy U.S. economic growth and military flare-ups in the Mideast and Ukraine.

He pegs the odds at about 30 per cent, versus a 60-per-cent chance of a sideways "rational exuberance" meandering. But he doesn't feel the melt-up will necessarily lead to disaster for investors.

"If stock prices melt up," he said in a note to clients, "we would expect that a significant year-end correction might bring the S&P 500 back down to 2,014."

In other words, even a correction would leave stocks higher than they are today, suggesting that the preceding melt-up would mark a significant rally from current levels.

So where's the harm in joining the rally if there are gains ahead?

If the busts of 2000 and 2008 offer a useful template, we tend to get the timing all wrong: We turn most enthusiastic about stocks at their peak, leaving us fully exposed to the following meltdown.

Sure, the global economy continues to expand, the Federal Reserve is showing no impatience with its easy-money policies and corporate earnings are providing some pleasant surprises.

But no one ever said that bad news drives melt-ups.

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