A valuation gauge dating back to 1871 has only reached today's level five times before, and each prior instance was followed by a market decline. The S&P 500, Dow Jones Industrial Average, and Nasdaq Composite are hovering near record highs even as the metric flashes its warning for a sixth time.
The S&P 500 (^GSPC), Dow Jones Industrial Average (^DJI), and Nasdaq Composite (^IXIC) are trading near record highs, powered by an unprecedented AI-driven capital spending cycle across data centers, chips, and power infrastructure. But beneath the rally, a long-running valuation gauge has climbed to a level reached only five times since 1871.
CAPE ratio hits 41.1, more than double its historical average
The cyclically adjusted price-to-earnings (CAPE) ratio, also known as the Shiller P/E, smooths out short-term earnings swings by measuring stock prices against average inflation-adjusted earnings over a ten-year horizon. The CAPE ratio's average reading since 1871 is about 17.8, while its current level of 41.1 is more than double that average.
There have been six periods when the CAPE ratio held above 30 for consecutive months during a broader bull market, and the current one is among them.
The five prior episodes ended in steep declines
The first came in 1929, when stock prices peaked during the Roaring Twenties before the infamous crash and the bear market that followed. Next, from 1997 to 2001, the CAPE reached an all-time high of about 44 during the dot-com boom, and the Nasdaq eventually dropped roughly 77% from peak to trough once the bubble burst.
The S&P 500 climbed for nearly a year before a sharp sell-off in the fourth quarter of 2018. Then, heading into 2020, stocks fell into a brief bear market within the first two months of the year as the pandemic shut down the global economy, though the recovery came quickly. Most recently, from 2020 to 2022, stocks rallied on stimulus and low rates until inflation peaked at about 9%, prompting the Fed to raise interest rates and pushing the S&P 500 into a 2022 bear market.
A Fed rate-hike worry adds to the pressure
Some investors are also growing concerned that new Federal Reserve Chairman Kevin Warsh could raise interest rates, which would lift the cost of capital for an economy pouring hundreds of billions of dollars into AI infrastructure annually. Since that build-out underpins the current rally, anything that slows its pace could fuel a nasty repricing.
A CAPE ratio above 30 does not mean prices will soon fall, since the market can stay expensive for a long time. History shows valuation is a warning light, not a stop sign.
Source: Motley Fool
Trading involves risk.
Risk Disclaimer
