The S&P 500 (^ GSPC + 0.22%) reported a price-to-earnings (CAPE) ratio of 39.2 in February. If that number means nothing to you, here’s the bottom line: The S&P 500 only set its highest CAPE ratio since the dot-com fall of 2000. The S&P 500 lost 49% of its value over the next two and a half years.
What is CAPE?
The CAPE ratio is a measure of how expensive the stock market is, comparing what investors pay to what companies actually earn.
The average P/E ratio compares the price to one year of earnings, which is good, but it can be misleading because one good or bad year can spoil the picture. The CAPE ratio — often called the Shiller P/E, after its creator, Yale economist Robert Shiller — accounts for that by averaging earnings over the past ten years and adjusting for inflation. It helps cut through the noise, giving you a clean way of reading whether a market is cheap, good quality or expensive.
Here is CAPE 30 years ago:
S&P 500 Shiller CAPE Ratio data by YCharts
Could this time be different?
Now, the bulls will argue this time is different; the AI revolution is generating real revenue growth, and the companies that manage the headlines are making money by hand, unlike the Pets.coms of 1999 and 2000. That’s a valid point. But, aside from the fact that faith has largely supported every bubble of the past, here’s what the data actually says about the return from these conditions.
Image source: Getty Images.
What history says about moving forward comes back to these situations
When the CAPE ratio is over 30, the S&P 500’s annual return is about 4%, according to Shiller research. At today’s level, the implied return is down about 2%.
Now, the ratio has remained high for a long time before. Investors who sold, they say, by the end of 2023, when CAPE crosses 30, would have missed a profit of more than 40% in the last two and a half years.
So, does a high CAPE guarantee a crash or a poor return? No, but there’s a huge mathematical possibility, and a high CAPE — especially as high as we see it today — is how corrections turn into risks. When rates are too high, stocks have to go down even more.
Why the growth of AI money may not be enough
I think there is good reason to believe that a significant reduction is possible. Although some big names are raising money today, the truth is that the real money so far has not reached where it matters most — the end user.
Nvidia continues to reap the rewards of the big AI technology capex spree, and while these companies have reported revenue growth and improvements in their bottom line, spending is dampening earnings. Acceptance at the consumer and business level is not enough to begin paying for the hundreds of billions spent.
And now the specter of recession hangs over the market, driven by rising oil prices stemming from the war in Iran. In the event of a recession, the S&P 500 has fallen an average of 32% from peak to trough.
How to prepare your portfolio
But this is no reason to be afraid to sell. First of all, I could be wrong — no indicator is perfect, and the market has a tendency to defy predictions. But even if a crash does occur, history is clear: In the last 11 months since 1950, the market has recovered in each one and gone on to set new all-time highs.
Often, the biggest damage comes not from getting out of a tight spot, but from trying to avoid it. Timing the market is notoriously difficult, and investors who sell during a downturn often close at a loss and miss the snapback. Some of the market’s strongest days often come right after the worst, and missing just a few days can seriously damage your long-term returns.
That said, this is a good time to review your portfolio. If you’re too weighed down by high-quality growth names in a business with future promises rather than current earnings, it might be worth weighing up companies with strong balance sheets, real profits, and sustainable competitive advantages.
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