The S&P 500(SNPINDEX: ^GSPC) is widely considered the best benchmark for the overall U.S. stock market. The index advanced 23% in 2024, marking the second consecutive year in which it returned more than 20%. That last happened 25 years ago in 1997 and 1998.
Importantly, after the S&P 500 advanced more than 20% in those back-to-back years, the index returned 19% in the third year. If the current situation plays out in the same way, the S&P 500 could have a blockbuster 2025.
Unfortunately, a second historical data point provides a crystal clear picture about what (eventually) happens next. The S&P 500 currently trades at valuation so expensive it has been during just two periods in history, and the index ultimately fell sharply following both incidents. Read on to learn more.
The S&P 500 trades at a historically expensive valuation
The cyclically adjusted price-to-earnings (CAPE) ratio is a valuation measure typically used to determine whether entire stock market indexes are cheap or expensive. The metric was developed and popularized by economist Robert Shiller during the dot-com bubble, so it is sometimes referred to as the Shiller PE ratio.
Whereas traditional price-to-earnings (PE) ratios are based on earnings from the trailing 12 months, CAPE ratios are calculated using the average inflation-adjusted earnings from the past decade. That eliminates the cyclical fluctuations in earnings that occur at different points in the business cycle to provide a more accurate picture of the stock market's valuation.
The S&P 500 had a CAPE ratio of 37.9 as of December 2024. To put that multiple in context, the index was created 814 months ago (March 1957), and only 35 times has its monthly CAPE ratio exceeded 37. In other words, the S&P 500 has only been this expensive 4% of the time throughout its nearly seven-decade history.
Here's the bad news: On occasions when the S&P 500's monthly CAPE ratio exceeded 37, the index declined by an average of 3% in the next year. The index also declined by an average of 14% in the next three years. But that does not necessarily mean the S&P 500 will be down one year from now, nor does it mean the index will be down three years from now.
The chart below shows the range of historical outcomes following incidents when the S&P 500 had a monthly CAPE ratio above 37.
Time Period
S&P 500's Best Return
S&P 500's Average Return
S&P 500's Worst Return
1 Year
20%
(3%)
(28%)
3 Year
34%
(14%)
(43%)
Chart created by author using data from Robert Shiller. Shown above is the best, average, and worst return in the S&P 500 during the 12 months and 36 months following times when its monthly CAPE ratio topped 37.
As shown above the S&P 500 does not always decline during the one-year and three-year periods following a monthly CAPE ratio above 37. So, it is possible that the U.S. stock market posts positive returns in the coming months and years. But history says a drawdown will occur at some point along the way.
As mentioned, the S&P 500 has only attained a monthly CAPE ratio above 37 during two periods in history: The first time was the dot-com bubble in the late 1990s, when investors overestimated the earnings potential of internet start-ups. The second time was in 2021, when investors underestimated how the Covid-19 pandemic would impact the economy.
Both times, the S&P 500 eventually sold off sharply. The index declined nearly 50% in the early 2000s as the dot-com bubble imploded, and it fell more than 25% in 2022 as high inflation led to recession fears. A similar outcome this time around is all but inevitable.
History says the S&P 500's current valuation cannot be sustained indefinitely
Here is the big picture: The S&P 500 had fantastic years in 2023 and 2024, but one reason for those returns is valuation-multiple expansion across the index. And history says the current CAPE ratio cannot be sustained indefinitely. That means a drawdown is as good as guaranteed at some point in the future.
In other words, the S&P 500 will eventually suffer a correction or bear market. The tips listed below can help investors prepare for that eventuality:
Never ignore valuation when buying a stock. If the valuation multiple is above the historical average, or expensive compared to the company's growth rate, consider waiting.
Slow your stock purchases in the current environment. Rather than investing every dime in stocks, start building a cash position (a large than normal one) in your portfolio.
Stay positive. The S&P has historically suffered a correction once every two years, and it has suffered a bear market about once every six years. But the stock market has always recovered.
That last point is particularly important. While market corrections and bear markets cannot be avoided, every single one has been a buying opportunity because the stock market has always recouped its losses and gone on to hit new highs. The next correction or bear market is a question of when (not if). But investors that view the event as a temporary sale on stocks may be less rattled by the experience.
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Trevor Jennewine 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.
