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Over 150 years of historical valuation data paints a grim picture for Wall Street. While there are always indicators or data points that hint at trouble for the U.S. economy or stock market, such as the significant decline in U.S. M2 money supply in 2023, one of the most alarming warnings comes from a key valuation tool used on Wall Street.
When investors think of valuation, they often consider the price-to-earnings (P/E) ratio. This ratio, calculated by dividing a company’s share price by its trailing 12-month earnings per share, offers a quick assessment of a stock’s price relative to its peers and the broader market. However, the P/E ratio can be skewed by growth stocks and unexpected events like economic downturns.
A more reliable measure of stock market valuation is the S&P 500’s Shiller P/E ratio, also known as the cyclically adjusted P/E ratio (CAPE ratio). This metric is based on the average inflation-adjusted earnings of the past 10 years, providing a more stable assessment that isn’t easily influenced by shocks or recessions.
Although the Shiller P/E ratio only gained recognition in the late 1990s, it has been back-tested over 154 years. As of the market close on Feb. 19, the S&P 500’s Shiller P/E stood at 38.75, nearing its highest level during the current bull market rally and more than double the historical average since 1871.
The current bull market is only the third time in history that the S&P 500’s Shiller P/E has exceeded 38, with previous instances in December 1999 and January 2022. These high readings were followed by significant market declines, such as the bursting of the dot-com bubble and the start of the most recent bear market.
Since 1871, there have been six instances, including the current one, where the Shiller P/E surpassed 30 for at least two consecutive months. In each of the past occurrences, the Dow Jones Industrial Average, S&P 500, and/or Nasdaq Composite experienced substantial declines in value.
In addition to the Shiller P/E ratio, another key valuation tool, known as the “Buffett Indicator,” has also raised concerns on Wall Street. This measure, endorsed by Warren Buffett as one of the best indicators of market valuations, calculates the total market cap of U.S. stocks relative to U.S. gross domestic product (GDP).
Recently, the Buffett Indicator reached an all-time high of 207.24%, significantly surpassing its historical average of 85%. This alarming level raises doubts about the current market valuations and suggests potential risks ahead.
The average has been on the rise over the years. Adjusting for fourth-quarter GDP data, it’s now higher than when Barchart highlighted the Buffet Indicator’s previous all-time high in December. Historical data shows that spikes in the Buffett Indicator above its long-term average have often signaled trouble for the stock market. For example, it surged past 195% before the 2022 bear market and exceeded 166% prior to the start of the COVID-19 crash.
While neither the Shiller P/E Ratio nor the Buffett Indicator is a timing tool, they have consistently forewarned downturns in the Dow, S&P 500, and Nasdaq Composite. A person smiling while reading a financial newspaper at home symbolizes this financial insight.
Time and perspective are crucial on Wall Street. While the thought of a significant market decline may be unsettling, a broader perspective can alter this view. Crestmont Research’s analysis, spanning from 1919 to 2024, reveals that all 106 rolling 20-year periods have yielded positive returns for S&P 500 investors.
Similarly, Bespoke Investment Group’s study emphasizes the significance of perspective. Notably, a new bull market was confirmed in June 2023, with the S&P 500 up 20% from its recent low. Historical data from Bespoke indicates that bear markets typically last around 9.5 months, while bull markets persist for approximately two years and nine months on average.
Despite short-term uncertainties, historical data consistently points to long-term growth potential for the Dow Jones, S&P 500, and Nasdaq Composite. Considering the current market scenario, it’s worth assessing investment opportunities carefully before making decisions.
Out of the numerous stocks considered, only the top 10 made the final cut, each potentially poised to generate significant returns in the future. A notable example is Nvidia, which was included in this list on April 15, 2005. Imagine if you had followed our recommendation and invested $1,000 at that time – you would now find yourself with an impressive $858,668!*
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Please note that Sean Williams currently does not hold any positions in the mentioned stocks. The Motley Fool endorses and has investments in Berkshire Hathaway. The Motley Fool adheres to a strict disclosure policy.
