Roughly two-and-a-half years ago, the iconic Dow Jones Industrial Average (^DJI 0.39%), widely followed S&P 500 (^GSPC 0.84%), and innovation-inspired Nasdaq Composite (^IXIC 1.55%) bottomed out during the 2022 bear market. Much of the ensuing 30-month stretch has featured optimists running the show.
But history is quite clear that while the stock market is a phenomenal long-term wealth creator, it doesn't move up in a straight line for extended periods.
Over the last four weeks, a level of volatility and uncertainty has returned to Wall Street that hasn't been witnessed in quite some time. Between Feb. 19 and March 13, the S&P 500 and Nasdaq Composite respectively lost 10.1% and 13.7% of their value. This placed both indexes in official correction territory -- i.e., down more than 10% from their highs.
While there's no denying that the recent plunge has created attractive price dislocations for select stocks, the unpleasant truth is that -- even with the S&P 500 and Nasdaq Composite well off their all-time highs -- the stock market remains historically pricey.
Image source: Getty Images.
Statistically, this is still a very expensive market
To state the obvious, value is subjective and in the eye of the beholder. What one investor considers to be pricey might be viewed as a bargain by another.
When most investors evaluate the relative cheapness or priciness of a stock or the broader market, they typically do so by using the price-to-earnings (P/E) ratio. This time-tested valuation tool is arrived at by dividing a company's share price by its trailing-12-month earnings per share (EPS). It's a quick method for evaluating mature businesses and major stock indexes, but it can be easily tripped up by shock events.
One of the best ways to measure where Wall Street's most widely followed stock index (S&P 500) lands on the valuation scale is by examining the S&P 500's Shiller P/E Ratio, which is also known as the cyclically adjusted P/E Ratio, or CAPE Ratio.
The Shiller P/E accounts for average inflation-adjusted EPS over the last 10 years. Accounting for a decade of EPS history, rather than just the trailing-12-months with the traditional P/E ratio, ensures that shock events and recessions can't skew the reading. In other words, it provides the closest thing to an apples-to-apples valuation measure you'll get on Wall Street.
S&P 500 Shiller CAPE Ratio data by YCharts.
In December 2024, the S&P 500's Shiller P/E Ratio closed at 38.89, which is the peak for the current bull market cycle, and the third-highest reading during a continuous bull market in history. When the benchmark index officially entered correction territory on March 13, the Shiller P/E closed at 34.47.
To put these figures into context, the average Shiller P/E for the S&P 500 when back-tested 154 years is 17.22. At its recent low point of 34.47, it was still double the average multiple since January 1871.
The historic correlation that investors would be wise to pay close attention to is how stocks have behaved when previously surpassing a Shiller P/E reading of 30. Including the present, there have only been a half-dozen instances in 154 years where this has occurred -- and the previous five were eventually followed by declines of at least 20% in the Dow Jones, S&P 500, and/or Nasdaq Composite.
History has pretty clearly demonstrated that premium valuations aren't tolerated over long periods. Even the most-expensive markets witnessed the Shiller P/E retrace to the mid-20 range. Over the last three decades, bear market declines have pushed the S&P 500's Shiller P/E down to an average of 22.
What these historic correlations point to is the unpleasant truth that the stock market is still historically pricey, even with the S&P 500 and Nasdaq Composite declining by a double-digit percentage.
Image source: Getty Images.
Companies with premium valuations are most at-risk, while dividend stocks can thrive
To qualify the previous discussion, keep in mind that your investment horizon plays a big role in defining just how cheap or pricey a stock or the broader market is to you. While stock market corrections and bear markets can be jarring and play on investors' emotions, they typically resolve rather quickly. The simple fact that the Dow Jones, S&P 500, and Nasdaq Composite increase in value over long periods often makes it more palatable for long-term investors to deal with historically pricey valuations.
Nevertheless, stocks that trade at decisive premiums to their industry or historic norms are typically those that take it on the chin during stock market corrections.
For example, artificial intelligence (AI) giant Palantir Technologies (PLTR 1.86%) has been the hottest thing since sliced bread over the last two years. Its AI-inspired cloud-based Gotham platform, which assists federal governments with collecting data and planning/executing military missions, is unique and not duplicable at scale. This operating segment is what's helped Palantir sustain 20%-plus sales growth and push to recurring profitability well ahead of expectations.
PLTR PS Ratio data by YCharts. PS ratio = price-to-sales ratio.
But on Feb. 19, when the S&P 500 hit its all-time closing high, Palantir stock came with a stone's throw of a price-to-sales (P/S) ratio of 100! To offer context on just how far outside of historic norms this is, Microsoft, Cisco Systems, and Nvidia all peaked at P/S ratios in the neighborhood of 30 to 40.
Palantir is one of many examples in the high-growth tech sector of companies with premium valuations that could be hit hard if the S&P 500 and Nasdaq stock market corrections steepen.
On the other end of the spectrum, investors typically seek out perceived-to-be safe stocks during periods of stock market turbulence. While there's no one-size-fits-all blueprint, safe stocks are often time-tested, recurringly profitable, and they usually pay a dividend.
The reason dividend stocks become so attractive during corrections is because of their historic long-term outperformance. In The Power of Dividends: Past, Present, and Future, the analysts at Hartford Funds, in collaboration with Ned Davis Research, found that dividend stocks crushed non-payers in the return column -- 9.17% annualized vs. 4.27% annualized -- over a half-century (1973-2023).
PM data by YCharts. Returns from Feb. 19-March 14.
For instance, tobacco stocks Philip Morris International (PM +3.21%) and Altria Group (MO +2.25%) haven't missed a beat since the stock market downturn began four weeks ago. Philip Morris stock is up more than 10%, while Altria Group has eked out a 1.4% gain.
Even though tobacco stocks aren't the growth story they were decades ago, they offer predictability during a period of uncertainty on Wall Street. Cigarette smokers have demonstrated a willingness to absorb price increases, and the addictive nature of nicotine, which is found in tobacco, keeps consumers loyal. Philip Morris International and Altria Group aren't going to knock investors' socks off like tech stocks have over the prior two years, but they're just the type companies that can thrive amid a pricey market that's vacillating right around correction territory.
