The Market’s Valuation Tool Flashes a Warning Sign - What Investors Should Know

Source: Yahoo Finance


Key Points:

  • The Shiller P/E ratio, a widely followed valuation metric, has entered overvalued territory again.
  • High valuations often precede market corrections — but the timing is unpredictable.
  • Valuations can stay high for years before a correction happens. Investors should focus on the long term.
  • Another concerning signal is the high valuations of the largest S&P 500 stocks compared to the rest of the index.
  • Corrections are a normal part of investing. Time in the market beats timing the market for long-term investors.

For the sixth time in the past 153 years, the S&P 500’s cyclically adjusted price-to-earnings ratio (CAPE), commonly known as the Shiller P/E, has climbed above the 30 level. This closely watched valuation metric is flashing a warning sign for the stock market, but long-term investors shouldn’t panic.

The Shiller P/E ratio averages inflation-adjusted earnings over the past 10 years to smooth out short-term profit fluctuations. At 31.44 as of July 13, 2023, the ratio is well above its long-term average of 17 and reaching levels that historically preceded market corrections.

Does this mean a crash is imminent? Not necessarily. As the saying goes, valuations are poor market timers. The market can stay overvalued for years before a substantial correction happens.

Still, investors should be aware of the risks posed by high valuations. Examining past instances when the Shiller P/E surpassed 30 provides useful context.

Five Previous Times Valuations Crossed Above 30

Looking back to 1870, there have been five previous times when the Shiller P/E decisively broke above the 30 threshold:

  • 1929: The ratio hit 30.2 in September 1929 right before the devastating crash and start of the Great Depression. The Dow Jones Industrial Average ultimately fell 89%.
  • 1937: After rebounding from the Depression lows, the ratio reached 30.1 in 1937. A 49% market correction followed over the next two years.
  • 1997–2001: The dot-com bubble drove the ratio above 30 for over four years, peaking at 44.2 in December 1999. The tech bust then chopped 49% off the S&P 500 over the next two years.
  • 2018: A market surge pushed the ratio to 33.3 in January 2018 before growth stocks rolled over. The S&P 500 fell 20% in the fourth quarter.
  • 2021-Present: Easy money policies during the pandemic helped propel the ratio over 30 again in late 2021. It remains elevated so far in 2023.

In all five of these previous instances, a minimum market decline of 20% eventually followed after valuations crossed above 30. The Average peak Shiller P/E was 35.6, for context.

But again, valuations can stay high for years before a correction hits. There are also unique factors in the current market, like structurally lower bond yields, that help justify elevated stock valuations.

The Key Lesson: Valuations Are Poor Market Timers

Here’s the key investing lesson — while high Shiller P/E readings signal lower long-term returns ahead, they provide little help for timing market moves.

For example, after first crossing above 30 in 1997, the ratio stayed extremely elevated all the way until 2001. A patient investor could have enjoyed several more years of gains before the dot-com bubble peaked.

On the other hand, some corrections have started not long after valuations got excessive. The Great Depression bear market began just months after the 1929 peak valuation reading.

At current levels, the Shiller P/E implies dismal S&P 500 returns of around 2% annualized over the coming decade, according to analysis from Goldman Sachs and Bank of America. But anyone predicting an imminent crash could be waiting a long time.

Forward P/E Ratio Also Flashing Warning Signs

Besides the Shiller P/E, the regular forward price-to-earnings ratio for the S&P 500 also appears stretched at 19.4.

The forward P/E divides the index’s current price by 2024 earnings per share estimates. This valuation metric hasn’t been this high heading into a bear market bottom in decades.

Most major market bottoms have coincided with forward P/E’s between 13 and 14. The fact that the ratio remained near 19 during the 2022 bear market reveals how highly valued the overall market still is compared to past cycles.

Another ominous signal is the wide valuation gap between the largest S&P 500 stocks and the rest of the index. The mega cap companies have an average forward P/E of 28.5, while the smaller components average just 16.3.

With sky-high valuations concentrated in heavyweight stocks like Apple, Microsoft, Amazon and Alphabet, a reversal in big tech could drag down the broader market averages.

But valuation metrics alone don’t determine when bear markets start or end. The Fed’s monetary policy pivot to lower rates fueled this rally off the 2022 bottom, despite still-high valuation signals.

Brace for Volatility, But Avoid Market Timing

The weight of evidence suggests investors should temper their return expectations and brace for bouts of volatility. However, trying to time market moves based on valuation signals is unlikely to pay off.

While high Shiller and forward P/Es indicate lower long-term returns for the S&P 500, they aren’t useful for predicting short-term direction. Stocks can keep chugging higher for some time even after valuations enter the danger zone.

Trying to jump in and out based on valuation or other predictive indicators often backfires horribly. Most market timers get whipsawed, earning lower returns than long-term buy-and-hold investors.

Since 1950, the S&P 500 has weathered 39 double-digit percentage corrections. With an average duration of just 1.88 years between dips, setbacks are normal and expected — almost routine from a long-term perspective.

History shows the stock market spends far more time rising than falling. Trying to avoid inevitable corrections often means missing out on subsequent gains when stocks rebound.

Bull markets last 3.5 times longer on average than bear markets. The S&P 500 gains 7.1% annually on average, dividends included. That healthy long-run return compensates investors for enduring occasional crashes and corrections.

Tune Out Short-Term Noise and Focus on Long-Term Goals

Rather than obsess over predicting the market’s next move, investors should develop a prudent asset allocation that fits their risk tolerance and time horizon.

Valuation metrics are useful for setting realistic return expectations, not for trying to time trades. Corrections and bear markets are inevitable risks with investing in stocks.

By tuning out short-term noise, following a disciplined strategy, and focusing on long-term goals, investors can overcome volatility to build wealth over decades. Time in the market beats timing the market.

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