When something makes history in the stock market, it's always best to clarify if it's good or bad history. Sometimes, history can be comforting; other times, it can be concerning. Needless to say, both have very different implications.
The S&P 500 (^GSPC 1.52%) is making history as one of the most expensive markets ever, based on the Shiller price-to-earnings (P/E) ratio, also known as the CAPE ratio.
This metric looks at the S&P 500's earnings over the past 10 years, adjusting them for inflation to prevent one-off events from skewing the numbers. For example, an event like a drop in corporate profits during the COVID-19 pandemic's height wouldn't cause the ratio to spike and be misleading.
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How expensive is the current S&P 500?
At the time of this writing, the Shiller P/E ratio is 40.22. This means investors are paying $40.22 per $1 of inflation-adjusted earnings of S&P 500 companies over the past decade. This is the second-highest ratio in S&P 500 history, trailing only the Shiller P/E ratio during the dot-com bubble, when it hit 44.19.
A high Shiller P/E ratio by itself isn't cause for concern because it's by no means an accurate predictor of when, or if, the stock market will drop. That said, what has historically happened once the ratio reaches high levels is worth keeping in mind and bringing a bit of caution.
In November 1999, the Shiller P/E ratio reached 44.19, and during the dot-com bubble crash, the S&P 500 declined by nearly half. In October 2021, the Shiller P/E ratio reached 38.58, and over the next 12 months, the S&P 500 declined by around 22%.
SNPINDEX: ^GSPC
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Should investors be worried about how expensive the S&P 500 is?
Just because something has happened in the past doesn't mean it'll happen in the future. However, it's wise to pay attention to correlations, so you can be prepared just in case. In my opinion, investors shouldn't be worried -- they should be aware of the why.
In this case, the why has a lot to do with how concentrated the S&P 500 has become and how that has contributed to its high valuation. As it stands, the "Magnificent Seven" companies account for around 35% of the S&P 500, with Nvidia, Apple, and Microsoft accounting for around a fifth of it.
They aren't solely to blame for the S&P 500's high valuation, but they are absolutely responsible for much of it, as the AI boom has sent many of their valuations skyrocketing. There's not a single stock in the S&P 500's top 10 holdings with a market cap below $1 trillion.
How should you approach investing in the S&P 500?
I'm a firm believer that consistently investing in the S&P 500 is one of the smartest moves investors can make. Personally, I invest in the Vanguard S&P 500 ETF (VOO 1.53%) using the dollar-cost averaging approach.
NYSEMKT: VOO
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Dollar-cost averaging involves investing a fixed dollar amount at regular intervals (ideally set beforehand), regardless of the share price. It's a way to stay consistent without being tempted to try to time the market.
The latter is hard to do because if you think the market will fall, it's easy to justify to yourself why you shouldn't invest right now. The opposite is also true, with convincing yourself to invest money in the market when you think prices will continue to rise.
By dollar-cost averaging in VOO, I know I'll sometimes buy shares when they're expensive, and vice versa. However, in the grand scheme of things, what matters to me is knowing I'm investing in a low-cost (0.03% expense ratio) ETF that holds world-class companies and has proven to be a great wealth-builder over time.
