In the past three years, the market has been red hot. The S&P 500 (^GSPC +0.55%) has risen by 77% during that stretch, with the excitement and growth opportunities around artificial intelligence (AI) making investors price many stocks up to new all-time highs. As a result, the index, which is a collection of the leading 500 companies in U.S. markets, has also been hitting new records.
The problem, however, is that like some individual stocks, the S&P 500's valuation has gotten incredibly inflated along the way. This suggests a significant decline could be around the corner. Is the stock market likely to crash in 2026?
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The Shiller P/E ratio hasn't been this high in decades
The Shiller price-to-earnings (P/E) ratio is an inflation-adjusted multiple based on earnings from the past decade. It's also known as the cyclically adjusted P/E (CAPE) ratio. It's a gauge of the S&P 500's valuation and can be used to compare one period to another.
Currently, the ratio is almost at 41. The last time it was this high was back during the early 2000s, right before the infamous dot-com crash. In 2021, it was at around 39, and the market would go on to crash the following year. Investors may be worried that another crash, fueled by the hype around AI, could be inevitable.
Is a stock market crash due in 2026?
The S&P 500 is trading at record levels, and it's coming off three straight years of strong gains that were north of the index's long-run average of around 10%. Adding to the concern about a possible bubble is that tech companies have been investing heavily in generative AI projects despite there not being a payoff for the vast majority of them, according to a study from MIT last year.
There's no shortage of reasons a crash may happen in the near future. But that doesn't mean one is coming, or that the solution is to dump all your investments and go into cash or load up on gold or silver. Valuations might climb even higher and lead to you missing out on possible gains.
Billionaire investor Warren Buffett has said that "we haven't the faintest idea what the stock market is gonna do when it opens on Monday -- we never have."
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How can you stay invested while protecting your portfolio?
If you're concerned about the stock market this year and about the S&P 500 in particular, there are ways to reduce some of your portfolio's risk. You can trim your positions in highly valued stocks and move into more modestly priced dividend stocks or value stocks in general. You might sacrifice some gains in exchange for safety, but these moves can help make your portfolio less vulnerable in the event of a crash or correction.
You can also invest in exchange-traded funds (ETFs) that have exposure to markets outside the U.S. or focus on specific sectors of the economy that don't experience significant volatility, such as utilities. With plenty of investment options out there, you aren't going to run out of possible choices and ways to diversify your portfolio.
If you have at least five-plus investing years left, you may also want to consider simply investing in S&P 500 index funds and just hanging on. In the event of a crash, you still have time to wait out a recovery down the road. And if a crash doesn't end up happening, you may end up benefiting from the index's continuing rise in value.
Ultimately, it comes down to your own personal risk tolerance and whether you'll need access to your funds sooner rather than later. But by focusing on valuations, dividends, and ETFs, you give yourself plenty of options for reducing your overall risk this year.
