In books and movies, you know to watch out whenever everything is going great for the main character. There's always some disruption that throws things off balance.
Investors could be in a similar situation right now. The S&P 500 soared 24% last year. The index has risen in the high single digits so far this year. Everything seems to be going great.
However, you won't have to look hard to find potential disruptions to this sunshine-and-roses market. One S&P 500 valuation metric is at the third-highest level ever. Could stocks be poised to plunge?
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A market priced at a premium
In 1988, economists Robert Shiller and John Y. Campbell introduced a new way to value stocks. They called it the cyclically adjusted price-to-earnings (CAPE) ratio. Over time, this metric also became known as the Shiller P/E ratio.
The CAPE ratio offers a twist on the widely used price-to-earnings (P/E) ratio. Instead of looking at only 12 months of earnings, it uses a 10-year average of earnings. The idea is that this longer period helps smooth out short-term volatility and provides a better valuation picture. A higher CAPE ratio reflects a steeper valuation and vice versa.
While the CAPE ratio can be used for individual stocks, it's also used with indexes such as the S&P 500. In particular, the S&P 500 CAPE ratio can help determine whether or not the index is priced attractively compared to historical levels.
The historical average CAPE ratio for the S&P 500 is around 16. Any value of 10 or less is considered low (and indicative of an attractive valuation). Any value of 25 or more is viewed as high (and reflects a market priced at a premium).
What is the S&P 500 CAPE ratio today? Over 34. The metric has peaked at a higher level only two times before -- in late 1999 and late 2021.
S&P 500 Shiller CAPE Ratio data by YCharts
CAPE fear
A sky-high S&P 500 CAPE ratio has frequently led to significant market declines in the past. For example, the valuation metric peaked in late 2021 at nearly 38.6. The next year, the S&P 500 sank more than 19%.
The highest S&P 500 CAPE in history was 44.2 set in late 1999. In 2000, the S&P 500 fell 10%. That decline was just the beginning. By the end of 2002, the index had plunged 40%.
There was also another time when the S&P 500 CAPE ratio spiked significantly. In September 1929, the valuation metric reached nearly 32.6. The infamous stock market crash of 1929 occurred the next month. The Great Depression followed.
These examples explain why some investors are fearful that stocks could plunge again with the S&P 500 CAPE ratio at such a high level. However, the metric was nearly as high in early 2021 yet the S&P 500 jumped 27% that year.
Some also think comparing the S&P 500 CAPE ratio to past levels isn't as useful as it once was. They note that there have been changes to accounting standards that impact how companies report earnings. They also argue structural changes including technological advancements enable companies today to generate higher earnings than in the past.
What should investors do?
An elevated S&P 500 CAPE ratio doesn't necessarily mean stocks are poised to plunge soon. However, there's no question that the S&P 500 is valued at a higher level than it has been historically.
I think investors would be wise to follow Warren Buffett's lead. The legendary Berkshire Hathaway CEO has amassed a massive cash stockpile. Importantly, though, Buffett hasn't run for the hills and sold many or all of Berkshire's positions.
However, he isn't buying stocks as much as when the market was priced more attractively. Buffett isn't staying on the sidelines completely. He bought several stocks in recent quarters, but none were valued at a premium.
That's a good strategy, in my view. Hold onto the stocks of well-run companies that are built to last. Build your cash position to take advantage of any future sell-off. When you see great stocks that are priced attractively, though, don't be afraid to buy them.
Remember in books and movies, a resolution always comes after the conflict. It works the same way with the stock market. Even if stocks fall because of high valuations, investors will eventually begin buying again. Over the long term, you should be able to have a Hollywood ending.
