It’s been a phenomenal two years for investors. Since bottoming out in October 2022, the iconic Dow Jones Industrial Average (DJINDICES: ^DJI)widely supported S&P500 (SNPINDEX: ^GSPC)and innovation-driven Nasdaq Composite (NASDAQINDEX: ^IXIC) have all risen to multiple record highs.
The epic rally in the stock market is fueled by the rise of artificial intelligence (AI), the excitement following President-elect Donald Trump’s victory, and corporate earnings growth that is easily exceeding consensus expectations.
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While nothing seems to stand in the way of these three catalysts, history is not so forgiving.
Over the past year, there has been no shortage of economic data points or forecasting tools that have warned of potential trouble for the U.S. economy and/or Wall Street. Examples include the first notable decline in the US money supply since the Great Depression, the longest yield curve inversion on record, and an all-time high for the ‘Buffett Indicator’. However, there’s a new concern to add to the list: the price-to-book ratio (P/B) of the benchmark S&P 500.
For individual companies, their book value effectively shows what shareholders would receive if a company were, hypothetically, liquidated (that is, its assets minus its liabilities). While book value is no longer the compelling fundamental measure it once was, it still serves an important function in helping value investors identify undervalued stocks.
However, book value is not just a measure used for individual companies. We can examine the collective book value of the companies that make up major indexes to determine whether the components as a whole are collectively cheap or pricey.
Over the past 25 years, the S&P 500’s price/earnings ratio has averaged 2.83, which is not particularly low, but not extremely high either. As the Internet democratized access to information in the mid-1990s and interest rates plummeted due to the financial crisis, investors have been encouraged to take on more risk and invest in growth stocks, which are expected to deliver higher price-to-earnings ratios.
But there is an undeniable threshold that the S&P 500 has crossed possibly (key word!) led to problems every time.
Before 2024, there were only two instances in a quarter century when the S&P 500’s price-to-earnings ratio exceeded 4 during a bull market rally:
As of the closing bell on November 26, 2024, the S&P 500’s price-to-earnings ratio stood at an all-time high of 5.30.
After the fourth quarter of 2021, the Dow Jones, S&P 500, and Nasdaq Composite all entered a bear market, with the S&P 500 losing about a quarter of its value. Meanwhile, the broad index lost 49% of its value when the dot-com bubble burst, while the Nasdaq Composite lost 78% on a peak-to-trough basis.
History is quite clear that once the S&P 500 price-to-earnings ratio expands, it is simply a matter of time before a significant correction occurs.
However, the S&P 500 breaking an unprecedented price-to-book threshold isn’t the only valuation metric raising eyebrows on Wall Street.
Most investors are probably familiar with the traditional price-to-earnings (P/E) ratio as a way to quickly assess whether a stock is cheap or pricey. To make this assessment, the price-to-earnings ratio divides a company’s share price (or index) into its earnings per share (EPS) over the last twelve months.
The potential problem with the traditional price-to-earnings ratio is that shock events make it useless. For example, early lockdowns during the COVID-19 pandemic hit corporate profits for a short period and distorted earnings per share over the past twelve months for most listed companies.
What may be a much more complete measure of value is the S&P 500’s Shiller P/E ratio, also called the cyclically adjusted P/E ratio (CAPE ratio). The Shiller P/E is based on average inflation-adjusted EPS over the past ten years, meaning it can smooth out the lumpiness associated with short-term shocks.
Tested back to 1871, the Shiller P/E has averaged a fairly modest reading of 17.17. But you’ll note that this ratio has been above this 153-year average for much of the past thirty years, again reflecting the democratization of information, easy access to online trading/investing, and lower prevailing interest. rates.
But when the closing bell rang on November 26, the Shiller P/E was at 38.41, which is the highest during the current bull market rally and also the third highest during an ongoing bull market of the past 153 years. The only two times the S&P 500’s Shiller P/E ratio has been higher are (drumroll) before the dot-com bubble burst when it reached an all-time high of 44.19, and immediately before the 2022 bear market when it was briefly surpassed. 40.
Since January 1871, there have been only half a dozen instances, including the current one, in which the S&P 500’s Shiller P/E has topped 30. After all five previous events, the benchmark index and/or the Dow Jones Industrial Average lost between 20% and 89% of their value.
Value may be in the eye of the beholder, but history couldn’t make it clearer that trouble is brewing for the stock market.
While the near-term prospects for the Dow Jones, S&P 500 and Nasdaq Composite seem risky at best based on a few historically impeccable valuation metrics, it becomes a very different story when investors lean on history and widen their lens.
A perfect example of how time works in investors’ favor can be seen in an analysis conducted by Crestmont Research, which is updated annually.
Crestmont researchers examined the 20-year rolling total returns, including dividends paid, of the S&P 500 dating back to 1900. Although the S&P didn’t exist until 1923, researchers were able to track the performance of its components in other indexes. dates from the early 20th century. Being able to backtest to 1900 resulted in 105 rolling 20-year periods, with end dates ranging from 1919 to 2023.
What Crestmont’s analysis showed is that all 105 rolling twenty-year timelines delivered positive total returns for investors. In other words, if an investor had, hypothetically, purchased an index fund that reflected the performance of the S&P 500 at any time since 1900 and held that position for 20 years, his initial investment would have grown.
Moreover, the Crestmont data set makes it clear that long-term investors were not getting by with sub-par profits. The annualized average total return for 50 of these 105 rolling twenty-year periods was over 9%, which on a compound annual basis would double an investor’s money every eight years.
Even as the stock market crosses unprecedented valuation thresholds, there is a extremely There’s a good chance that the Dow Jones Industrial Average, the S&P 500, and the Nasdaq Composite will be significantly higher in 20 years.
Consider the following before purchasing shares in the S&P 500 Index:
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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
The stock market just crossed an unprecedented threshold – and history couldn’t be clearer about what will happen next originally published by The Motley Fool
