Title: Uncommon Event in the Stock Market: A Look at its Previous Occurrences and Consequences
The S&P 500 (–0.34%), often viewed as the benchmark for the entire U.S. stock market, has delivered an impressive 27% return so far this year, placing it among its strongest performances of the 21st century. However, signs of potential trouble are emerging.
According to a November survey conducted by the Conference Board, 56.4% of U.S. consumers anticipate the stock market to rise in the forthcoming year — the highest optimistic stance recorded. While this may sound promising, Morgan Stanley perceives it as a warning signal of excessive optimism at a time when valuations are stretched.
Indeed, the S&P 500 has attained a valuation last witnessed during just two periods in 1985—the dot-com bubble and the onset of the Covid-19 pandemic. In both instances, the index plummeted afterwards.
The S&P 500 is overpriced
Currently, the S&P 500 sports a forward price-to-earnings (P/E) ratio of 22.3. That figure represents a considerable premium compared to its five-year average of 19.7 times forward earnings and 10-year average of 18.1 times forward earnings. FactSet Research reports that this level of overvaluation was last reached in April 2021.
In actuality, the S&P 500 has breached the 22x forward P/E threshold only twice since 1985. In the first instance, during the dot-com bubble, the forward P/E multiple surpassed 22 in 1998 and remained above that level for about three years. The index subsequently declined by 49% following its peak in March 2000.
The second time the forward P/E ratio exceeded 22 was during the Covid-19 pandemic. Investors underestimated the lasting impact of supply chain disruptions and stimulus spending on the economy, thus driving many stocks to outrageous valuations. Subsequently, the S&P 500 declined by 25% after peaking in January 2022 — amidst the most severe inflation surge in 40 years.
In essence, the S&P 500 has breached the 22x forward P/E barrier on two occasions since 1985, and in both instances, the index dropped significantly afterwards. Although forward P/E ratios can be subject to inaccuracies due to their reliance on earnings estimates, considering the latest PE ratio based on trailing 12-month earnings resolves this issue.
Presently, the S&P 500 is trading at 28.7 times earnings, marking a considerable premium compared to its five-year average of 24.1 times earnings and 10-year average of 21.9 times earnings. As per LPL Research, the S&P 500 has never amassed a positive 10-year return when its initial PE multiple exceeded 25.
A positive outlook for investors
In October, Goldman Sachs updated its 10-year forecast for the S&P 500. While analysts predict the benchmark index to generate a 3% annual return during the next decade—significantly below its long-term average of 11%—they identified a potential silver lining for investors.
Goldman analysts highlighted that the expansion in valuations is largely attributed to a select handful of stocks. The higher-than-usual valuations for the top 10 stocks correspond to the dot-com boom in 2000. This means that the other 490 stocks in the index are less overvalued, offering room for potential growth.
Consequently, Goldman analysts anticipate an equal-weight S&P 500 index fund to generate an 8% annual return in the coming decade, outperforming the traditional S&P 500 (which is weighted by market capitalization) by 5 percentage points per year.
In conclusion, the S&P 500’s current forward P/E ratio, which suggests an overvalued market, indicates the importance of being cautious while investing in the current market environment. Considering this, now may be an appropriate time to set aside some extra savings, as these funds could be significant when the next correction or bear market occurs.
Despite the optimistic consumer sentiment, institutional investors like Morgan Stanley are expressing concerns about excessive optimism in the market, given the S&P 500's current high valuations. This high valuation, indicated by the S&P 500's forward price-to-earnings ratio of 22.3, is a warning sign for some analysts. They argue that the S&P 500 has only exceeded this valuation twice since 1985, during the dot-com bubble and the Covid-19 pandemic, both of which were followed by significant market declines.
Thus, even though some investors may see an opportunity in the current market conditions, it's essential to approach investing with caution due to the high valuations and potential risks.
