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Should You Buy an S&P 500 Index Fund at Record Levels?

Last week the S&P 500 index (SNPINDEX: ^GSPC)composed of the 500 largest U.S. companies by market capitalization, reached another all-time high, hitting $5,341.88 intraday on Thursday, May 23.

An S&P 500 index fund has long been touted by Warren Buffett as his investment of choice for those who don’t have time to closely study individual stocks. And last week’s milestone certainly seems to justify this statement.

But with the stock market recently hitting a new all-time high, AI enthusiasm perhaps getting a little fizzled, and interest rates and inflation remaining stubbornly higher than we’d like, is it really a good time to buy the S&P 500 today?

The arguments against buying the S&P 500 here

For those who are cautious about the markets, there are plenty of good reasons to hold off on buying the stock market averages. First, as a market cap-weighted index, the S&P is dominated by big tech companies that have soared recently as part of a bull market that has essentially lasted since October 2022.

The combination of interest rates appearing to be peaking, inflation falling from a peak of 9.1% in June 2022 to just 3.4% last month, and the tailwinds of the artificial intelligence boom have major tech companies looking for new , pushed to new heights.

And new heights are not only reached by Nvidia (NASDAQ: NVDA)which just reached an eye-watering market cap of $2.6 trillion with a high price-to-earnings ratio of 62. Most of the cloud giants, as well as their associated semiconductor stocks, have also surged higher on strong perceived growth that is set to continue. indefinitely in the future.

But will that be the case? After all, AI investments will have to justify their ultimate benefits to businesses and consumers, and companies are now spending unprecedented amounts on AI chips and data centers for fear of being left behind. Sounds familiar? This current boom has faint echoes of the rise of the dotcom in the late 1990s, which enjoyed a few years of boom when the Internet mania hit, before the bubble burst in 2000. That breakup led to an epic crash and recession, creating an unprecedented crisis. three straight years of declines for the tech-heavy Nasdaq Composite, which fell an epic 76.8% from peak to trough, while the S&P 500 fell a milder but still sickening 49.1%.

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Could the AI ​​bubble burst in a similar way? AI’s momentum certainly doesn’t seem to be stopping anytime soon. But on the other hand, few saw the crash of 2000 coming, believing that Internet hypergrowth would continue forever and not return to GDP growth rates. One day, it’s likely there will be an AI company reporting a slowdown or digestion of growth, and these high-flying stocks could correct in a big way. Will that day happen soon? Probably not, but it’s hard to say.

Meanwhile, inflation influences what the Federal Reserve will do with interest rates, and higher interest rates tend to depress both stock valuations and the economy. With inflation remaining somewhat sticky and disappointing compared to expectations over the past few months, the Federal Reserve may need to keep rates high for longer to reach its 2% inflation target.

That could be a problem since the S&P 500 is trading at a historically above-average valuation. Today, the S&P 500 index currently trades at 27.6 times trailing earnings. That’s actually quite high by historical standards, as the average rating for the index over history is 16.1.

So if interest rates and inflation rise again, it could certainly be a dangerous time to invest in this frothy market.

Man on top of a mountain of money with a flag.

Image source: Getty Images.

Reason to buy the S&P 500

On the other hand, as the famous investor Peter Lynch once said, “there is always something to worry about” in the markets.

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Although the average price-to-earnings ratio of the S&P 500 has been much lower throughout market history than it is today, the market has tended to trade at a higher price-to-earnings ratio in recent years. In fact, the average over the past ten years is around 22.5. While this is below current prices, it is still much closer. If you hadn’t invested in the stock market over the past decade for fear of high valuations, you would have missed out on a 236% gain, including dividends, over that period.

^SPXTR diagram^SPXTR diagram

^SPXTR diagram

Furthermore, the average return of the S&P 500 since 1928 through 2023, when the Standard & Poor’s index was first developed, is approximately 9.9%, with dividends reinvested. And since the index was formally expanded to 500 companies in 1957, the long-term annualized return has been even better: 10.3%.

Of course, there have been several specific moments, just on the brink of a massive market crash, when one might not have wanted to invest. However, this is evident from a study by Ben Carlson, author of the blog A wealth of common sense, points out that if your time horizon is long enough, even investing at market peaks just before stock market crashes can still pay off in the long run. Carlson looked at the returns on theoretical investments made just before eight of the market’s worst crashes, from September 1929 to October 2007, before the Great Recession of 2008.

Five years later, three of those investments would still have yielded positive results. Ten years later, six of these eight investments would have been profitable, with three delivering triple profits. And twenty years after we invested at the eight worst possible times in market history, all eight would have been profitablewith returns for every investment except September 1929 yielding a profit of hundreds of percent.

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Stick to your share plan

Of course, wise investing does not just mean one-off, large investments. If you save a portion of your income and average dollar costs each month in an index fund, you are indeed investing ahead of certain market peaks, but you can also average that out by investing in subsequent recessions.

Market crashes are extremely difficult, if not impossible, to predict. But as we have seen from history, even investments made before the worst market peaks and crashes eventually heal themselves, because corporate America’s profits grow over time. Meanwhile, trying to time the market can cost you a lot of money, as we’ve seen from those who haven’t been in the market in the last decade.

That’s why the S&P 500 seems like a great buy today, even at its high valuation, provided you have a consistent investment plan and stick to regular monthly, quarterly or annual investments.

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Billy Duberstein and/or his clients have no positions in the stocks mentioned. The Motley Fool has positions in and recommends Nvidia. The Motley Fool has a disclosure policy.

Should You Buy an S&P 500 Index Fund at Record Levels? was originally published by The Motley Fool

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