The S&P500 (SNPINDEX: ^GSPC) is widely considered the best indicator of the entire US stock market. The index has returned 27% year to date, one of the strongest performances of the 21st century. But warning signs are starting to appear.
In November, a Conference Board survey found that 56.4% of U.S. consumers expect the stock market to rise in the coming year, the highest figure ever. That may sound like good news, but… Morgan Stanley considers it a contrarian indicator pointing to irrational optimism at a time when valuations are under pressure.
Do you miss the morning spoon? Wake up with Breakfast news in your inbox every market day.
The S&P 500 recently reached a valuation seen in only two other periods since 1985, and the benchmark index ultimately crashed after both incidents. Read on for more information.
The S&P 500 currently has a price-to-earnings ratio (PE) of 22.3. That is a material premium compared to the five-year average of 19.7 times forward earnings and the ten-year average of 18.1 times forward earnings. According to sources, the stock market has not been this expensive since April 2021 FactSet research.
In fact, the S&P 500 has only achieved a price-to-earnings ratio of more than 22 for two periods since 1985. The first time was the Internet bubble. The forward PE multiple floated above 22 in 1998 and generally stayed above that level for about three years. The S&P 500 ultimately fell 49% from its peak in March 2000.
The second time the price-earnings ratio exceeded 22 was during the Covid-19 pandemic. Investors underestimated the deep supply chain disruptions and stimulus spending that would impact the economy, and bid up many stocks to absurd valuations. After peaking in January 2022, the S&P 500 ultimately fell 25% amid the worst wave of inflation in four decades.
In summary, the S&P 500 has traded at more than 22x gains for just two periods since 1985, and both times the index has (eventually) fallen sharply. Of course, forward PE multiples are prone to inaccuracy because they are based on earnings estimates. But we can consider the current price-to-earnings ratio (calculated based on the last twelve months’ earnings) to solve that problem.
Currently, the S&P 500 trades at 28.7 times earnings. That is a significant premium compared to the five-year average of 24.1 times earnings and the ten-year average of 21.9 times earnings. And according to LPL Research, the S&P 500, which dates back to 1990, has never generated positive ten-year returns when its initial price-to-earnings ratio exceeded 25.
In October, Goldman Sachs updated its 10-year outlook for the S&P 500. Analysts expect the benchmark index to generate a total return of 3% per year over the next decade. That is well below the long-term average of 11% per year. But the report contained an important silver lining for investors.
While Goldman attributed its gloomy outlook to historically high valuations, a handful of companies are the main culprit. “The premium valuation for the top ten stocks is the largest since the 2000 dot-com boom,” analysts wrote. This means that the remaining 490 stocks are more attractively priced, which in itself implies more upside potential.
As a result, Goldman analysts estimate that an equally weighted S&P 500 index fund will earn an annual return of 8% over the next decade, beating the traditional S&P 500 (which is weighted by market cap) by 5 percentage points per year . This forecast reflects their belief that the top ten stocks will struggle to outperform over the next decade.
Here’s the bottom line: The S&P 500 is currently trading at a historically expensive price-to-earnings ratio, meaning investors should be especially cognizant of valuations when buying stocks in the current market environment. Plus, now is a great time to raise some extra cash. Doing this will make it easier to profit from the next correction or bear market.
Have you ever felt like you missed the boat on buying the most successful stocks? Then you would like to hear this.
On rare occasions, our expert team of analysts provides a “Double Down” Stocks recommendation for companies they think are about to pop. If you’re worried that you’ve already missed your chance to invest, now is the best time to buy before it’s too late. And the numbers speak for themselves:
-
Nvidia: If you had invested $1,000 when we doubled in 2009, you would have $359,936!*
-
Apple: If you had invested $1,000 when we doubled in 2008, you would have $46,730!*
-
Netflix: If you had invested $1,000 when we doubled in 2004, you would have $492,745!*
We’re currently issuing ‘Double Down’ warnings for three incredible companies, and another opportunity like this may not happen anytime soon.
See 3 “Double Down” Stocks »
*Stock Advisor returns December 9, 2024
Trevor Jennevine has no position in any of the stocks mentioned. The Motley Fool holds positions in and recommends FactSet Research Systems and Goldman Sachs Group. The Motley Fool has one disclosure policy.
The stock market is doing something it’s only done twice since 1985, and history is clear on what will happen next originally published by The Motley Fool
