For the better part of the last four years, Wall Street’s bull market has been unstoppable. Since early June, the time-tested Dow Jones Industrial Average (DJINDICES:^DJI), benchmark S&P 500 (SNPINDEX:^GSPC), and technology-driven Nasdaq Composite (NASDAQINDEX:^IXIC) have all blasted to fresh record highs.
Investors are finding no shortage of reasons to be excited about equities, including (but not limited to):
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The artificial intelligence (AI) infrastructure build-out
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Far better-than-expected corporate earnings
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Record S&P 500 share buyback activity
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Historic initial public offerings
But as the popular idiom goes, “when things seem too good to be true, they usually are.”
Image source: Getty Images. Image source: Getty Images.
While history can’t guarantee what’s to come, past events, more often than not, can foreshadow the future.
At the moment, the stock market is on the verge of doing something that no investor has witnessed in the last 156 years. Based on previous milestones leading to this point, trouble (and potentially a stock market crash) may be brewing.
Stock market valuations are approaching uncharted territory
Just as there’s a laundry list of things going right for the stock market, there’s also a long list of headwinds threatening to end Wall Street’s AI-driven rally, such as rapidly rising margin debt, persistently elevated inflation, and surging long-duration bond yields.
But based solely on history, there’s perhaps nothing more frightening for investors than premium stock valuations.
Defining “value” is tricky because there isn’t a blueprint for evaluating every public company or the broader market. When individual investors evaluate and value businesses, they incorporate some degree of emotion and/or subjectivity. The absence of a one-size-fits-all value approach is what makes accurately predicting short-term directional moves in the Dow, S&P 500, and Nasdaq Composite so challenging.
However, one time-tested valuation tool has done a remarkable job of providing investors with apples-to-apples comparisons of broad market valuations throughout history: the S&P 500’s Shiller P/E Ratio, also known as the Cyclically Adjusted P/E Ratio (CAPE Ratio).
What gives the Shiller P/E Ratio a leg up over all other valuation tools is that it’s based on average inflation-adjusted earnings over the last 10 years. Whereas earnings turning negative during recessions can make the traditional P/E ratio useless, this isn’t the case with the Shiller P/E Ratio.
