The stock market is doing something it has only done twice since 1985, and history clearly tells us what will happen next
this S&P 500 Index (SNPINDEX:^GSPC) Widely considered the best indicator of the entire U.S. stock market. The index has returned 27% so far this year, making it one of the strongest performers of the 21st century. But warning signs are starting to appear.
In November, a Conference Board survey found that 56.4% of U.S. consumers expected stocks to rise next year, the highest reading on record. This sounds like good news, but Morgan Stanley Consider this a contrarian indicator, signaling irrational optimism when valuations are too high.
Did you miss the morning scoop? wake up with breakfast news In your inbox every market day. Register for free »
In fact, the S&P 500 has recently reached valuations it has only seen in two other periods since 1985, with the benchmark ultimately plunging following both events. Read on to learn more.
The S&P 500 currently has a forward price-to-earnings ratio of 22.3. This represents a significant premium to the five-year average expected earnings of 19.7 times and the 10-year average expected earnings of 18.1 times. Stocks haven’t been more expensive since April 2021, according to market research firm fact set research.
In fact, since 1985, the S&P 500 has only achieved a forward P/E ratio above 22 in two periods. In 1998, forward price-to-earnings ratios drifted above 22 and generally remained above that level for about three years. The S&P 500 peaked in March 2000 and ended up down 49%.
The second time the forward P/E ratio exceeded 22 was during the Covid-19 pandemic. Investors have underestimated the extent of the economic impact of supply chain disruptions and stimulus spending, and they have overvalued many stocks. After peaking in January 2022, the S&P 500 ended up falling 25% amid the most violent wave of inflation in 40 years.
All told, since 1985, the S&P 500 has only traded at a P/E ratio above 22x twice in two periods, and the index (eventually) fell sharply both times. Of course, forward P/E ratios are prone to inaccuracies because they are based on earnings forecasts. But we can address this by considering the current P/E ratio (calculated using earnings over the last 12 months).
Currently, the S&P 500’s price-to-earnings ratio is 28.7 times. This is significantly higher than the five-year average P/E ratio of 24.1 times and the ten-year average P/E ratio of 21.9 times. Since 1990, the S&P 500 has never produced positive 10-year returns when its initial price-to-earnings ratio exceeded 25 times, according to LPL Research.
