(FORTUNE Magazine) –

On Aug. 26, Alan Greenspan delivered a valedictory speech in balmy Jackson Hole, Wyo., that contained a wintry warning. Investors, the Fed chairman intoned, normally demand a substantial "risk premium"--a high return in exchange for taking a chance that they may lose money. Now, though, investors "accept increasingly low compensation for risk." They are acting, he said, as if owning stocks or houses has suddenly become much less uncertain than it has been over the past century. Under these conditions, he concluded, "any onset of investor caution elevates risk premiums and lowers asset values. History has not dealt kindly with the aftermath of low risk premiums."

The chairman's chilling words attracted scant attention, but investors should treat them as holy writ. Greenspan spotlights a problem that everyone from Wall Street gurus spouting happy talk on CNBC to homebuilders touting the "new paradigm" in real estate choose to ignore. Let's translate his warning into plain language: Most investments are extremely expensive right now if measured against historical norms. At best, people who buy at today's levels are in for a sustained period of subpar returns, perhaps 4% or 5% annually, after inflation. That's because the best predictor of future gains is the price you pay. "High prices and low risk premiums today mean low returns tomorrow," says Cliff Asness, an economist who runs AQR Capital, a $17 billion hedge fund. The more dire alternative is a steep fall in prices that makes everything from the S&P 500 to homes what they aren't today--that is, great investments.

Greenspan's argument rests on the idea of the risk premium--the extra return (over a supersafe investment like Treasury bills) that investors have traditionally received for putting their money in peril. For stocks, the risk premium equals the expected real (inflation adjusted) return on a broad portfolio of shares, minus the real interest rate. To calculate the risk premium that stock investors are getting today, we turned to Asness. For expected return, Asness uses the earnings yield on the S&P 500--earnings per share divided by price--adjusted for cyclical swings in profits. Asness pegs today's earnings yield at 4.3%.

To derive the real interest rate, Asness takes today's ten-year Treasury yield of 4.6% and subtracts the average inflation rate over the past five years, 2.7%, to get a real rate of 1.9%. So today's risk premium is the 4.3% expected return minus the 1.9% real interest rate, or 2.4%. That's about half the 5% margin that stocks have delivered for the past 80 years. So investors aren't getting the usual extra bang for holding equities.

The question is whether investors will remain satisfied with that 2.4% edge. It's conceivable that a combination of lower transaction costs and enlightened monetary policy has sharply cut the risk of owning stocks. If so, it would make sense for stock investors to accept lower returns. On the other side of the scale is the weight of history: Whenever risk premiums have fallen to today's piddling lows, they've always bounced back to far higher levels.

How far would prices have to drop to bring the risk premium up to normal levels? In a 2002 paper, professors Kenneth French of Dartmouth and Eugene Fama of the University of Chicago estimate that stock market investors would accept a premium of 4%. To reach that figure today, the expected return would have to climb to 5.9%. That would require the market's P/E ratio to fall to 16.9, which would work out to a 27% decline in the S&P 500.

But the fall could be much worse. That's because interest rates are still far below their customary levels. Since 1965, real interest rates have averaged 2.8%, half again as high as today's 1.9% figure. If the risk premium goes to 4% and real rates return to the norm, the stock market's average P/E would drop to 14.7 and prices would plunge 37%.

Indeed, the dramatic drop in real rates helped ignite the boom in asset prices. But rates have almost doubled since late 2004. "Real rates under 2% just aren't sustainable," says Mark Zandi of Economy.com. "As the economy expands, demand for capital will rise. That will push up real rates and push down asset prices."

What about seeking refuge in other asset classes? The situation is no better and arguably worse. Let's start with fixed income. For corporate bonds, the risk premium is simply the spread between the yields on corporates and T-bills. Today investment-grade issues pay less than one percentage point more than comparable Treasuries, about half the recent average. Junk bonds yield only two to three points more than Treasuries, vs. the customary four to five points.

Real estate is also saddled with a shrunken risk premium. For nearly every type of property, the "cap rate," or yield--the net rental income divided by the market price--is at an all-time low. On apartment buildings it stands at 5.5% to 6%, vs. its historical average of 8% to 9%. "Today's prices ... don't reflect the true risk," says Gleb Nechayev, an economist with Boston real estate forecasting firm Torto Wheaton Research.

What can a prudent investor do? Steer clear of real estate and fixed income. It's likely that yields from both will be far better a year from now than they are today. But investing selectively in stocks could prove fruitful, if you follow these rules: First, buy value stocks--those trading at a discount to their peers based on earnings growth or book value. These stocks tend to boast far bigger earnings yields than the market as a whole, and hence are better shielded from the kind of drastic repricing likely to pummel high P/E stocks. Second, dividends are good: Companies that pay big dividends actually increase their earnings far faster than those that don't, mainly because they are more prudent with their scarce cash.

Third, hold down fees. In a low-return world those 1.5% mutual fund charges really hurt. It's best to go with index funds. Fourth, market timing isn't all bad. That doesn't mean you should become a day trader. But when prices are at the extremes, as they are today, it's best to keep a lot of cash on hand so you can jump back in when P/Es drop and the risk premium returns to normal. Will it happen? When Greenspan is moved to issue an unambiguous warning, who are you gonna believe--Wall Street touts or the wrinkly wizard?