In roughly a week and a half, Wall Street will turn the page on what will likely be another outstanding year. Even with some mid-week volatility, the iconic Dow Jones Industrial Average(DJINDICES: ^DJI), benchmark S&P 500(SNPINDEX: ^GSPC), and growth-propelled Nasdaq Composite(NASDAQINDEX: ^IXIC) have respectively risen by 12%, 23%, and 29%, as of the closing bell on Dec. 18. This is well above the average annual return for equities over the long run.
But as is often the case, when things seem too good to be true on Wall Street, they usually are.
Image source: Getty Images.
Based on a handful of valuation tools, we're witnessing one of the priciest stock markets in history. Statistically speaking, there's a heightened possibility of increased volatility and/or downside for the Dow Jones, S&P 500, and Nasdaq Composite in 2025.
Let's take a closer look at what the new year may bring for Wall Street, and I'll share what moves I've made (and not made) in anticipation of a potentially challenging year.
Stocks are historically pricey -- and that's (usually) bad news
For more than a year, there have been a few predictive tools, correlative events, and data points that have foreshadowed imminent trouble for the stock market and/or U.S. economy. Some examples include the first meaningful year-over-year drop in U.S. M2 money supply since the Great Depression, the longest yield-curve inversion in history, and the correlation between Federal Reserve rate-easing cycles and the performance of equities.
However, the most damning of all forecasting tools and data points might just be the S&P 500's Shiller price-to-earnings (P/E) ratio, which is also known as the cyclically adjusted P/E ratio (CAPE Ratio).
The most common of all valuation tools among investors is the traditional P/E ratio, which is arrived at by dividing a company's share price by its trailing-12-month (TTM) earnings per share (EPS). The P/E ratio is a quick and easy way for investors to gauge whether a company is relatively cheap or pricey compared to its peers and the broader market.
But the P/E ratio isn't perfect. It doesn't factor in growth rates and it can be easily disrupted by shock events. For instance, lockdowns during the COVID-19 pandemic rendered TTM EPS unusable for about a year. This is where the Shiller P/E comes in handy.
The S&P 500's Shiller P/E is based on average inflation-adjusted EPS from the prior 10 years. Examining a decade of inflation-adjusted EPS history minimizes the impact of shock events and leads to apples-to-apples valuation comparisons for the broader market.
When the closing bell tolled on Dec. 18, the Shiller P/E stood close to its year-to-date high of almost 39. For context, the S&P 500's Shiller P/E has averaged a reading of 17.19 since January 1871.
As you might have noticed from the Shiller P/E chart above, it's spent much of the last 30 years above its 153-year average reading. This is a reflection of the internet democratizing information and access to trading for everyday investors, as well as lower interest rates encouraging risk-taking.
But there's also a limit to how high valuations can go before reality pushes back.
Over the last century, there have been six instances where the Shiller P/E has surpassed 30, including the present. Following all five prior occurrences, the S&P 500, Dow Jones Industrial Average, and/or Nasdaq Composite declined by 20% to 89%. Though there's no telling precisely how long valuations can stay extended, history is quite clear that premium valuations are eventually (key word!) met with sizable pullbacks time and time again.
Today's Shiller P/E equates to the third-priciest stock market on record, dating back to 1871.
Image source: Getty Images.
Here's my five-point plan for investing in what may be a challenging 2025
Since I've been an investor for over a quarter of a century and have navigated my way through four of the previous five instances when the Shiller P/E topped 30, there's a pretty consistent blueprint I follow for tackling a potentially volatile and challenging stock market. Specifically, there are five goals I aim to achieve when stocks valuations are historically pricey.
1. Stay the course with core holdings: Regardless of what any valuation tool or predictive indicator suggests is coming, stock market downturns have historically been short-lived. According to a data set released by Bespoke Investment Group in June 2023, the average S&P 500 bear market has resolved in an average of 286 calendar days since the start of the Great Depression in September 1929. By comparison, the typical S&P 500 bull market lasts more than 1,000 calendar days.
Long story short, I don't tend to do much, if anything, with most of my core holdings. I'm a long-term investor at heart, and the vast majority of my 35 portfolio holdings have been fixtures for between one and 13 years.
2. Nibble on value stocks: During periods of heightened volatility, investors tend to flock to the safety of value stocks. Though it's considerably tougher to find value stocks in the third-priciest stock market on record, there are a few companies here and there that remain attractive.
As an example, I've been eyeing pharmaceutical giant Pfizer(NYSE: PFE) closely over the last couple of weeks. Pfizer stock has been hammered by a big-time pullback in COVID-19 therapeutic sales over the last two years -- more than $56 billion, combined, in 2022 from Comirnaty and Paxlovid versus a forecast of $8.5 billion from the two, combined, in 2024.
Nevertheless, Pfizer's net sales are on track to have grown by 46% since the end of 2020, based on the midpoint of the company's 2024 sales guidance. This is impressive organic growth for a company valued at less than 9 times forward EPS and with a yield of 6.5%.
3. Home in on dividend stocks: To build on this previous point, I tend to focus on adding a dividend stock or three to my portfolio when the stock market is historically pricey. Pfizer's yield has approached 7%, which is an all-time high for the company. But it's not the only income stock I'd be looking to buy.
For instance, I'd love to add to my stake in business development company (BDC) PennantPark Floating Rate Capital(NYSE: PFLT), which doles out a monthly dividend and is yielding north of 11%!
Although the entirety of PennantPark's loan portfolio sports variable rates and the Fed is in the process of lowering interest rates, the pace at which it expects to lower rates in 2025 should slow noticeably. In other words, PennantPark has a clear path to continue generating a double-digit weighted-average yield on its debt investments in the new year.
4. Dump broken-thesis stocks: Let's face the facts -- not everything you're going to buy turns out to be a winner. When the stock market is historically pricey, it's as good a time as any to offload positions that no longer pass the sniff test or meet your initial or updated investment thesis.
For instance, I pulled the plug on telehealth services provider Teledoc Health(NYSE: TDOC) this year. While the concept of telehealth services seems like a no-brainer investment opportunity, the sheer amount of competition within the space, coupled with Teledoc's aggressive spending, has weighed heavily on the company.
Though it's possible changes made by insurers to lower healthcare treatment costs could promote telehealth services in a big way in the second half of the decade, my initial thesis on Teledoc had been broken. A pricey stock market is the perfect time to dump positions you're no longer confident in.
5. Have plenty of dry powder at the ready: Lastly, I make it a point to have ample cash available to take advantage of the emotion-driven trading and price dislocations that often accompany short-lived stock market corrections and bear markets.
As of Dec. 19, nearly 20% of my portfolio was made up of cash. I'll generally hold anywhere from 15% to 30% of my portfolio's value in cash when the Shiller P/E crosses well above 30 in anticipation of the phenomenal deals to come.
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Sean Williams has positions in PennantPark Floating Rate Capital. The Motley Fool has positions in and recommends Pfizer and Teladoc Health. The Motley Fool has a disclosure policy.
