Wall Street has been on one heck of a roller-coaster ride since this decade began. The revered Dow Jones Industrial Average (^DJI 0.40%), broad-based S&P 500 (^GSPC 1.02%), and growth-stock dominated Nasdaq Composite (^IXIC 2.02%) have endured two bear markets (in 2020 and 2022), as well as a period of investment euphoria (2021) that sent all the major indexes to new highs.
Through the first eight months of 2023, euphoria looks to be back on the map. The S&P 500 and Nasdaq Composite are higher by 15% and 31%, respectively, as of the closing bell on Aug. 28, and all three major indexes have reentered a bull market, based on at least one definition.
But before uncorking the champagne and welcoming back the exuberance than sent the Dow, S&P 500, and Nasdaq Composite to new highs just two years ago, investors need to face one very clear fact: Stocks are expensive. Historically speaking, that's never been a particularly good thing for Wall Street.
Image source: Getty Images.
Stocks have been this pricey only a half-dozen times in 150 years
The valuation indicator that really demonstrates just how pricey stocks are at the moment is the S&P 500's Shiller price-to-earnings (P/E) ratio, which is also commonly known as the cyclically adjusted price-to-earnings ratio, or CAPE ratio.
Whereas a traditional P/E divides a company's share price into its trailing-12-month earnings per issued share, the Shiller P/E ratio is based on average inflation-adjusted earnings over the past 10 years. Examining 10 years' worth of earnings history, as opposed to one year, smooths out the impact of potentially wild profit swings from major economic events, such as COVID.
The other advantage to the Shiller P/E is that it's been successfully back-tested to 1870. Even though the S&P didn't come into existence until 1923, and the Shiller P/E ratio wasn't published until the 1980s, the components of the S&P could be found in other major indexes prior to its creation. This has allowed for accurate back-testing of valuations for more than 150 years.
As of the closing bell on Aug. 28, the S&P 500's Shiller P/E stood at 30.58, which is notable figure for two reasons. For starters, it's nearly double the average reading of 17.05 over the past 153 years.
S&P 500 Shiller CAPE ratio data by YCharts.
To some extent, higher valuations since the mid-1990s can be explained by the internet breaking down information barriers for everyday investors. Being able to pull up income statements and management commentary at the click of a button has leveled the playing field for retail investors. When coupled with historically low lending rates for more than a decade following the Great Recession, risk-taking has been more palatable for investors.
The more-glaring concern is that this marks only the sixth time since 1870 that the S&P Shiller P/E ratio has crossed above 30 and held that mark. Investors have eventually (key word!) paid the price for extended valuations in the previous five instances.
Following the Black Tuesday crash in October 1929, the Dow Jones Industrial Average eventually went on to lose almost 90% of its value. On the other end of the spectrum, the persistent decline in equities observed during the fourth quarter of 2018 saw the benchmark S&P 500 shed 20% of its value. All five previous instances in which the S&P Shiller P/E surpassed 30 have eventually resulted in at least a 20% drawdown in the market's most-followed stock index.
The one caveat to the above is that valuations can stay extended for an indeterminate amount of time. Whereas some periods of pricey valuations -- meaning a Shiller P/E north of 30 -- were corrected in a matter of weeks (e.g., 1929), the Shiller P/E spent roughly four years above 30 leading up to the dot-com bubble bursting. Eventually, though, reality always catches up to Wall Street, and fundamentals do matter.
Image source: Getty Images.
Playing the long game negates near-term valuation concerns
Based solely on what history tells us, the valuations of the Dow Jones, S&P 500, and Nasdaq Composite are liable to come down in the not-too-distant future. This is consistent with a number of predictive tools that suggest the U.S. economy is poised to weaken in the coming quarters.
But this is also a guess as to what Wall Street will do in the short run. While history has shown that this "guess" has a pretty good chance of being right, it's not a guarantee. If investors want the closest thing they can get to a guarantee on Wall Street, they would be smart to ignore most of the short-term white noise and focus on the long game.
Take the cyclicality of the U.S. economy as a perfect example. Recessions are a normal and inevitable part of the economic cycle. But recessions and expansions are far from mirror images of one another.
Since World War II ended, the 12 recessions the U.S. has navigated its way through have lasted just two to 18 months. Meanwhile, most periods of economic expansion have been measured in years.
In fact, the expansion that was ended by the pandemic lasted longer than a decade. Disproportionately long periods of expansion allow corporate earnings to grow over time. While recessions are inevitable, they're also short-lived and play a clear second fiddle to periods of expansion.
This disproportionate "bullishness" is also on display in the stock market. Although the U.S. economy and major stock indexes aren't tied at the hip, bulls spend a considerably longer amount of time smiling, relative to the bears. Based on data from Bespoke Investment Group, the average bear market over the past 94 years has lasted 286 calendar days. That compares with the typical bull market, which has endured for an average of 1,011 calendar days since September 1929.
In other words, it simply pays to be optimistic. If history is right and valuations do come down, long-term investors should use a decline in the major stock indexes as an opportunity to pounce.
