The past two years have been quite the adventure for Wall Street and investors. In the second half of 2021, the ageless Dow Jones Industrial Average (^DJI 0.40%), broad-based S&P 500 (^GSPC 1.02%), and growth-fueled Nasdaq Composite (^IXIC 2.02%), notched multiple all-time highs. In 2022, all three indexes stumbled into a bear market. As for 2023, it's been all systems go, with the Dow, S&P 500, and Nasdaq Composite decisively in the green.

When the stock market gets whipsawed over a relatively short timeline, new and tenured investors are often left wondering when the volatility will end, and where the major indexes will head next.

A view of George Washington's portrait on a one dollar bill next to a newspaper clipping of a falling stock chart.

Image source: Getty Images.

Although there isn't an end-all market indicator that can, with 100% accuracy, predict which direction stocks will move in the short run, there are various indicators and metrics that offer strong correlations with directional moves in the Dow, S&P 500, and Nasdaq Composite.

At the moment, one widely followed market indicator has a clear take on what the future may hold for stocks.

For the sixth time in 153 years, this popular market metric is overextended

While there are a number of stock market indicators, metrics, and probability tools that can be used to make educated guesses about directional moves for the broader market, the one I'm focusing on today puts a spotlight on stock valuations. I'm talking about the S&P 500's Shiller price-to-earnings (P/E) ratio, which is also commonly known as the cyclically adjusted P/E ratio, or CAPE ratio.

With the standard P/E ratio, a company's share price is divided into its trailing-12-month earnings per share. However, the Shiller P/E ratio is based on average inflation-adjusted earnings over the previous 10 years. Analyzing earnings over a 10-year period eliminates the profit vacillations that can occasionally arise in a single year (e.g., such as during COVID-19).

When back-tested to 1870, the Shiller P/E ratio has averaged 17.04 over 153 years. But as of the closing bell on July 13, 2023, the S&P 500's Shiller P/E stood at 31.44, which is its highest reading in more than a year.

S&P 500 Shiller CAPE Ratio Chart

S&P 500 Shiller CAPE Ratio data by YCharts.

To be fair, the S&P 500's Shiller P/E values have been above historic norms for much of the past 25 years. Considerably lower lending rates have fueled growth stocks, while access to online investing, and the ability to gather information at the click of a button, has made Wall Street freer and fairer than ever for everyday investors. In other words, investors have been willing to accept higher valuations and take on more risk.

But there is a limit to valuations on Wall Street, and the Shiller P/E ratio has, once again, found itself in the danger zone.

Looking back to 1870, there have only been six instances where the S&P 500's Shiller P/E decisively crossed above 30. Aside from the current move, the other five instances eventually led to declines ranging from 20% on the low end for the S&P 500 in the fourth quarter of 2018, to 89% on the high-end for the Dow Jones Industrial Average during the Great Depression. Though a move of this magnitude is highly unlikely in today's market, the key takeaway is that when valuations become extended to the upside, a minimum decline of 20% has eventually followed.

The caveat to the above is that valuations can stay extended for some time. The S&P Shiller P/E was effectively north of 30 from June 1997 till August 2001.  In other words, the Shiller P/E doesn't offer any context on when a downturn in stocks might occur. It simply suggests that an eventual decline of at least 20% awaits the S&P 500.

A magnifying glass laid atop a financial newspaper, which has enlarged a subhead that reads, Market data.

Image source: Getty Images.

Another valuation metric provides an ominous warning to Wall Street

However, the S&P 500 Shiller P/E isn't the only valuation tool that suggests investors be cautious. The benchmark index's forward P/E ratio also provides an ominous warning to Wall Street.

When the closing bell rang on July 13, the S&P 500 had a forward P/E of 19.4. The forward P/E ratio divides the S&P 500's point value into Wall Street's consensus earnings per share figure for the index in the upcoming year.

On a relative basis, a forward P/E of 19.4 is within its historic range of 9 to 26 over the past quarter of a century.  But there are two unnerving aspects of this forward P/E figure that deserve further attention.

To begin with, no bear market or sizable stock market correction has ended over the last 25 years with the S&P 500's forward P/E higher than 14. In fact, most of Wall Street's sizable downturns found their "support" with the S&P 500 trading between 13 and 14 times its forward-year earnings. The 2022 bear market bottomed with a forward P/E of around 15.5, which would make it the priciest market to bounce back from a decline of at 20%.

The other concern is that a very small number of S&P 500 components is driving the bulk of the upside on Wall Street. As of June 2, the 10-largest S&P 500 companies by market cap had an average forward P/E ratio of 28.5. Meanwhile, the remaining 490 companies by market cap had a more modest average forward P/E of 16.3. Though the S&P 500's average forward P/E of 19.4 appears modest, there's sizable risk from the now-outsized valuations of some of its largest components.

These valuation indicators would seem to concur that eventual downside is likely in the Dow Jones, S&P 500, and Nasdaq Composite.

Time is on your side

While this may not be the news you wanted to hear, given that the major indexes are breaking through to new 52-week highs, it's not terrible news, either, if you're an investor with a long-term mindset.

As much as we may dislike stock market corrections and bear markets, they're a perfectly normal part of the long-term investing cycle. Data from sell-side consultancy firm Yardeni Research shows there have been 39 double-digit percentage declines in the S&P 500 since the start of 1950. This works out to a correction, on average, every 1.88 years.

^DJI Chart

^DJI data by YCharts.

But did you realize that, with the exception of the 2022 bear market, every previous dip, correction, bear market, and crash in the Dow, S&P 500, and Nasdaq Composite, was eventually wiped away by a bull market rally? Even though we'll never know precisely when a downturn will begin, how long it'll last, or ultimately how much the broader market will decline, history conclusively shows that, over long periods, the major indexes head higher.

Furthermore, optimists spend a lot more time in the sun. Based on data provided by Bespoke Investment Group, the benchmark S&P 500 spends considerably more time in a bull market than in a bear market.

Using the definition that a bull market begins when the S&P 500 rallies 20% following a 20%+ decline, the average bull market has lasted 1,011 calendar days since 1929. By comparison, the average bear market has taken 286 calendar days to run its course. In short, the average bull market lasts 3.5 times longer than the typical bear market, which is why it pays to be an optimist.

While no stock market indicator or metric is perfect, time is the one factor that's consistently on your side. If you invest for the long-term and allow your theses to play out over many years, if not decades, there's a high likelihood you'll grow your wealth, no matter what short-term valuation metrics have to say.