Last week was eventful for Wall Street, to say the least. On Monday, Jan. 20, Donald Trump became only the second president to serve two nonconsecutive terms. During President Trump's first term in the White House (Jan. 20, 2017-Jan. 20, 2021), the iconic Dow Jones Industrial Average(DJINDICES: ^DJI), widely followed S&P 500(SNPINDEX: ^GSPC), and growth-dependent Nasdaq Composite(NASDAQINDEX: ^IXIC)surged by 57%, 70%, and 142%, respectively.
On Tuesday, Jan. 21, the joint venture known as Stargate was unveiled, which will feature $500 billion in investments (spread over four years) to build out the necessary infrastructure to accommodate the rise of artificial intelligence (AI) in America.
But perhaps the crème de la crème is the benchmark S&P 500 ending Jan. 23 at a fresh record-closing high of nearly 6,119. For context, the S&P 500 erased a roughly 5% pullback from its previous high in just a little over one week.
While this is the type of history investors love to see Wall Street make, the current bull market is also knocking on the door of something that's been historically troublesome.
Image source: Getty Images.
Wall Street is pushing stock valuation boundaries to the limit
While most economists have been focused on the probability of a U.S. recession taking shape, a record-breaking yield-curve inversion, and the first notable decline in U.S. M2 money supply since the Great Depression, the stock market has, quietly, pushed itself to a valuation premium that's only been witnessed a few times before.
Before digging any deeper, let's state the obvious: Valuation is subjective. Depending on your risk tolerance, investment horizon, and area(s) of focus, what one investor considers to be pricey might be viewed as a bargain by another.
With this being said, Wall Street's bull market is on the cusp of unwanted history.
Arguably, the best valuation tool that allows for the clearest apples-to-apples comparisons is the S&P 500's Shiller price-to-earnings (P/E) ratio. You'll also find the Shiller P/E referred to as the cyclically adjusted P/E ratio (CAPE ratio).
Unlike the traditional P/E ratio, which is limited to just trailing-12-month earnings per share (EPS), the Shiller P/E is based on average inflation-adjusted EPS over the prior decade. Adjusting for 10 years' worth of earnings history ensures that wild vacillations in EPS can't skew the measurement.
When the closing bell tolled on Jan. 23, the S&P 500's Shiller P/E ended at 38.59, just shy of its closing high in December 2024 of 38.89. More importantly, this valuation tool is knocking on the door of topping 39 for only the third time in history, when back-tested to January 1871. The other times include a reading of 40 during the first week of January 2022, and the all-time high of 44.19 in December 1999.
To demonstrate just how rare this multiple is, the S&P 500's Shiller P/E has averaged a reading of 17.2 when back-tested 154 years. In other words, the close on Jan. 23 was 124% above the 154-year average.
While there are some viable reasons that explain why valuations have remained above the long-term average for much of the last three decades, such as the democratization of information and the proliferation of online trading, there's a worrisome precedent that's been set anytime the S&P 500's Shiller P/E has surpassed 30 for any notable length of time.
Since 1871, there have been just six occurrences, including the present, where the Shiller P/E topped 30 for at least two consecutive months. Following each of the previous five instances, the S&P 500, Dow Jones Industrial Average, and/or Nasdaq Composite shed anywhere from 20% to 89% of their value.
If there's one thing the Shiller P/E isn't particularly useful for, it's forecasting when these declines will begin. Whereas premium valuations lasted just two months prior to the Great Depression taking shape, they endured more than four years when the dot-com bubble burst.
But what has been clear throughout history is that premium valuations, as shown by the Shiller P/E, are a harbinger of trouble for Wall Street.
Image source: Getty Images.
Where there's the prospect of peril, there's also promise
Based on what history tells us, the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite appear likely to move notably lower in the not-too-distant future. While this may not be what bull market enthusiasts want to hear, it's not all bad news.
The stock market wouldn't be a "market" if it didn't move in both directions from time to time. Corrections, bear markets, and even crashes, are normal events within the long-term investing cycle.
But if investors widen their lens beyond the next few quarters or even years, they'll come to two important realizations.
To begin with, peril leads to promise on Wall Street. Even though we'll never know ahead of time precisely when a downturn will begin, how long it'll last, or how steep the decline will be, history teaches us that, eventually (key word!), the Dow, S&P 500, and Nasdaq Composite will ascend to new heights. If you're an investor with a long-term mindset, it means stock market corrections, bear markets, and crashes represent the ideal time to put your money to work.
Perspective also helps investors recognize the nonlinearity of the investing cycle. Just because downturns/bear markets are normal and inevitable, it doesn't mean they're a mirror image of bull markets.
In a data set published on X by Bespoke Investment Group in June 2023, researchers compared the calendar-day length of every bull and bear market in the S&P 500 dating back to the start of the Great Depression. This data set showed the average S&P 500 bear market endured only 286 calendar days, while the typical bull market stuck around for 1,011 calendar days -- roughly 3.5 times as long.
Regardless of what the short term has in store for Wall Street, history favors investors who take a step back and widen their lens.
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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.
