Stocks have only been this expensive 3 times in 153 years — and you won’t like what happened on the previous two occasions

For the last century, stocks have been on a pedestal of their own. Although other asset classes, including Treasuries, gold, oil and housing, have produced positive nominal returns, nothing else has come close to generating the annualized total return that stocks have delivered.

Despite this outperformance, stocks are not moving higher in a straight line. From point A to point B, the journey resembles a winding road full of various potholes and speed bumps.

Even if the ageless ones Dow Jones Industrial Average (^DJI -1.01%)standard S&P 500 (^GSPC -1.73%)and focused on growth Nasdaq Composite (^IXIC -2.55%) are all firmly in a bull market, and just a stone’s throw from their respective all-time highs, one valuation tool suggests the party will come to an abrupt end.

Image source: Getty Images.

Stocks are historically expensive, and that spells trouble for Wall Street

For more than a year, we have examined no shortage of market events, data points and valuation metrics that have, throughout history, strong correlated with moves higher or lower in the broader market. Examples include the first significant decline in US M2 money supply since the Great Depression, the longest yield curve inversion on record, and the broader market’s performance after the start of a rate easing cycle.

However, the one tool that causes major problems for Wall Street is the Shiller price-to-earnings (P/E) ratio of the S&P 500. You’ll sometimes see the Shiller P/E referred to as the cyclically adjusted price-to-earnings ratio or the CAPE ratio.

There is probably no valuation metric that investors are more familiar with than the traditional P/E ratio, which divides a company’s stock price by its earnings per share (EPS) over the past 12 months. Meanwhile, the Shiller P/E takes into account average inflation-adjusted EPS over the past decade. Considering 10 years of EPS history ensures that short-term shocks such as the COVID-19 lockdown do not negatively impact valuation models.

S&P 500 Shiller CAPE Ratio data by YCharts. CAPE ratio = cyclically adjusted price-to-earnings ratio.

When the closing bell rang on September 5, the S&P 500 Shiller P/E was at 35.38, more than double its average of 17.16 since January 1871. As you’ll note from the chart above , the Shiller P/E has spent much of the past 30 years above 20, which is likely a function of the Internet democratizing access to information and interest rates being below historical norms.

The scary thing for Wall Street and investors is that in 153 years, stocks have collectively been more expensive on only two separate occasions than now. During the dot-com boom, the Shiller P/E reached an all-time high of 44.19. Meanwhile, in the first week of January 2022, the Shiller P/E briefly crossed 40.

In the years following the dot-com peak, the S&P 500 went on to lose 49% of its value, while the innovation-driven Nasdaq Composite lost 78% of its value from peak to trough. The other instance of the Shiller P/E reaching 40 in January 2022 was followed by a bear market for the Dow Jones, S&P 500 and Nasdaq Composite.

Since 1871, there have been six occasions when the S&P 500’s Shiller profit share has broken through and supported 30 during a bull market rally, including the current one. All five previous events resulted in the Dow, S&P 500 and/or Nasdaq Composite losing between 20% and 89% of their value.

While the Shiller P/E is not a timing tool — valuations can remain stretched out for weeks, months or even years — it foreshadows a big decline in stocks without fail when tested more than a century ago. With the stock at its third-highest valuation in history, there is a strong the likelihood of a sizeable pullback in the coming months/years.

Image source: Getty Images.

Perspective is one of the most powerful tools investors have

While forecasting a significant decline in the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite probably won’t sit well with most investors, the bottom line is that time is very much on investors’ side, and perspective changes everything. .

For example, a number of predictive indicators point to economic weakness in the not-too-distant future. A long inversion in the yield curve between the 10-year Treasury bond and the three-month T-bill signaled one of the highest probabilities for a US recession seen since the early 1980s.

As much as working Americans and investors may dislike recessions, they are a normal and inevitable part of the business cycle. Most importantly, they have a track record of quick resolution. Of the 12 US recessions since the end of World War II, nine were completed in less than a year, while the other three failed to make it past 18 months.

On the other side of the coin, two economic expansions have topped the decade mark since September 1945, with most periods of growth lasting several years. The business cycle is not linear and undoubtedly favors the far-sighted to bet on long-term expansion.

What is worth noting is that we see the same non-linearity in the stock market.

It’s official. A new bull market is confirmed.

The S&P 500 is now up 20% from its 10/12/22 closing low. In the previous bear market, the index fell 25.4% in 282 days.

Read more at https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp

— Bespoke (@bespokeinvest) June 8, 2023

In June 2023, shortly after it was confirmed that the S&P 500 was in a new up market, following a 20% rebound from its 2022 lows, researchers at Bespoke Investment Group published the dataset you see above up on X (social media platform). formerly known as Twitter). This data set detailed the length of every bull and bear market in the S&P 500 since the start of the Great Depression in September 1929.

The 27 S&P 500 bear markets over 94 years have lasted an average of 286 calendar days, or about 9.5 months. On the other hand, the 27 strong markets since the Great Depression endured an average of 1,011 calendar days, about 3.5 times longer. You can also notice that nearly half (13 of 27) of S&P 500 bull markets were longer than the longest bear market.

Even without being able to tell when stock market corrections will begin, how long they will last, or how steep the decline from peak to trough will be, investors’ ability to step back, widen their lens and examine the picture puts time and history in their corner. Regardless of the stock market decline that may await, based on what the Shiller P/E ratio suggests, long-term investors are well positioned for success.