The S&P 500 (^GSPC +0.84%) crashed when President Trump announced sweeping tariffs in April. But the index has since rebounded 33% from its low and is currently on the verge of delivering a positive return for the fifth consecutive month.
The economy has been more resilient than investors initially feared, and S&P 500 earnings were better than expected in the first and second quarters. Nevertheless, Warren Buffett recently sent investors a $177 billion warning and history says the stock market could struggle over the next few years.
Here's what you should know.
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Berkshire Hathaway sold a net total of $177 billion in stock over the last 11 quarters
Berkshire Hathaway (BRK.A +0.16%) (BRK.B +0.18%) owns more than 180 subsidiaries that operate across several industries, but its insurance businesses are the primary source of operating income. Warren Buffett and his fellow investment managers use that capital to acquire or purchase stock in other companies with the goal of further increasing operating income.
Berkshire was a net buyer of stocks during the bear market of 2022, meaning the value of stocks purchased exceeded the value of stocks sold. But the company flipped its stance shortly after the market hit bottom and has now been a net seller for 11 straight quarters. Its net sales totaled $177 billion during that period.
That constitutes a grim warning for investors when considered alongside another fact: Berkshire had $344 billion in cash and U.S. Treasury bills on its balance sheet as of the second quarter. That means the company has plenty of cash, but Buffett has simply chosen not to invest it. The most likely explanation: He cannot find many stocks worth buying due to elevated valuations.
The S&P 500 trades at an expensive valuation that has historically correlated with negative 3-year returns
The cyclically adjusted price-to-earnings (CAPE) ratio is used to determine whether stock indexes (usually the S&P 500) are overvalued. While the traditional PE ratio compares the current market value of an asset to its earnings from the trailing 12 months, the CAPE ratio substitutes average inflation-adjusted earnings from the past decade to smooth out natural volatility in the business cycle.
The S&P 500 over the last month had an average CAPE ratio of 38. That is an unusually high valuation. In fact, the index has recorded a monthly CAPE ratio higher than 37 just 41 times since its inception in 1957, a period that covers 825 months. Said differently, the S&P 500's CAPE ratio has only topped 37 about 5% of the time in history.
The S&P 500 has typically performed poorly following monthly CAPE readings above 37. The chart below shows the average return over the next one, two, and three years.
|
Holding Period |
S&P 500 Return When CAPE Ratio Is 37+ |
|---|---|
|
1 Year |
(3%) |
|
2 Years |
(12%) |
|
3 Years |
(14%) |
Data source: Robert Shiller. Note: Returns are not annualized.
As shown above, the S&P 500 has usually declined during the one, two, and three years after CAPE readings above 37. And if its performance matches the historical average, the index will drop 3% over the next year and it will still be down 14% in three years.
There is an important disclaimer: No stock market forecasting tool is perfect. The S&P 500 has on certain occasions generated reasonably good returns after its monthly CAPE ratio topped 37. However, the stock market is undoubtedly expensive today. So, investors need to be particularly cognizant of valuations when buying stocks.
Indeed, a machine learning algorithm created by Moody's shows a 48% probability of a recession in the next 12 months. The algorithm, which was developed recently but back-tested to 1960, seems to be remarkably accurate: Every reading above 50% was followed by a recession, and the model predicted every economic downturn during that period.
The upshot for investors is the economy is on somewhat shaky ground due to weakness in the jobs market and the unpredictable impact of President Trump's tariffs. So, it would be prudent to error on the side of caution when making investment decisions in the current market environment.
